An Interest Rate is the Rate at Which Interest is Paid by a Borrower for the Use of Money That They...

8/2/2019 An Interest Rate is the Rate at Which Interest is Paid by a Borrower for the Use of Money That They Borrow From a

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An interest rate is the rate at whichinterestis paid by a borrower for the use of money that theyborrow from alender. For example, a small company borrows capital from a bank to buy newassets for their business, and in return the lender receives interest at a predetermined interest ratefor deferring the use of funds and instead lending it to the borrower. Interest rates are normallyexpressed as apercentageof theprincipalfor a period of one year[1].

Interest rates targets are also a vital tool ofmonetary policyand are taken into account whendealing with variables likeinvestment,inflation, andunemployment.

Historical interest rates

Germany experienced deposit interest rates from 14% in 1969 down to almost 2% in 2003

In the past two centuries, interest rates have been variously set either by national governments orcentral banks. For example, the Federal Reservefederal funds ratein the United States has variedbetween about 0.25% to 19% from 1954 to 2008, while theBank of Englandbase rate variedbetween 0.5% and 15% from 1989 to 2009,[2][3]and Germany experienced rates close to 90% in

the 1920s down to about 2% in the 2000s.[4][5]During an attempt to tackle spiralinghyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to800%.[6]

This section requiresexpansion.

The interest rates on prime credits in the late 1970s and early 1980s were far higher than hadbeen recordedhigher than previous US peaks since 1800, than British peaks since 1700, orthan Dutch peaks since 1600; "since modern capital markets came into existence, there havenever been such high long-term rates" as in this period.[7]

Possibly before modern capital markets, there have been some accounts that savings depositscould achieve an annual return of at least 25% and up to as high as 50%. (William Ellis andRichard Dawes, "Lessons on the Phenomenon of Industrial Life... ", 1857, p III-IV)
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Interest Rates in the United States

In the United States, authority for interest rate decisions is divided between the Board ofGovernors of the Federal Reserve (Board) and theFederal Open Market Committee(FOMC).The Board decides on changes in discount rates after recommendations submitted by one or more

of the regional Federal Reserve Banks. The FOMC decides on open market operations, includingthe desired levels of central bank money or the desired federal funds market rate.

[edit] Reasons for interest rate change

Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under

normal conditions, most economists think a cut in interest rates will only give a short term gain in

economic activity that will soon be offset by inflation. The quick boost can influence elections. Most

economists advocate independent central banks to limit the influence of politics on interest rates.

Deferred consumption: When money is loaned the lender delays spending the money on

consumptiongoods. Since according totime preferencetheory people prefer goods now to goods

later, in a free market there will be a positive interest rate. Inflationary expectations: Most economies generally exhibitinflation, meaning a given amount of

money buys fewer goods in the future than it will now. The borrower needs to compensate the

lender for this.

Alternative investments: The lender has a choice between using his money in different

investments. If he chooses one, he forgoes the returns from all the others. Different investments

effectively compete for funds.

Risks of investment: There is always a risk that the borrower will gobankrupt, abscond, die, or

otherwisedefaulton the loan. This means that a lender generally charges arisk premiumto ensure

that, across his investments, he is compensated for those that fail.

Liquidity preference: People prefer to have their resources available in a form that can immediately

be exchanged, rather than a form that takes time or money to realize.

Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on a

higher rate to make up for this loss.

Real vs nominal interest rates Further information:Fisher equation

The nominal interest rate is the amount, in money terms, of interest payable. For example, suppose a household deposits $100 with a bank for 1 year and they receive

interest of $10. At the end of the year their balance is $110. In this case, thenominalinterest rateis 10% per annum.

The real interest rate, which measures thepurchasing powerof interest receipts, iscalculated by adjusting the nominal rate charged to takeinflationinto account. (Seereal

vs. nominal in economics.) If inflation in the economy has been 10% in the year, then the $110 in the account at the

end of the year buys the same amount as the $100 did a year ago. Thereal interest rate, inthis case, is zero.

After the fact, the 'realized' real interest rate, which has actually occurred, is given by theFisher equation, and is
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where p = the actual inflation rate over the year. Thelinear approximation

is widely used. The expected real returns on an investment, before it is made, are:

where: = real interest rate

= nominal interest rate = expected or projected inflation over the year

Market interest rates

There is amarketfor investments which ultimately includes themoney market,bond market,stock marketandcurrency marketas well as retail financial institutions likebanks.

Exactly how these markets function is a complex question. However, economists generally agree

that the interest rates yielded by any investment take into account:

The risk-free cost of capital

Inflationary expectations

The level of risk in the investment

The costs of the transaction

This rate incorporates the deferred consumption and alternative investments elements of interest.

[edit] Inflationary expectations

According to the theory ofrational expectations, people form an expectation of what will happentoinflationin the future. They then ensure that they offer or ask a nominal interest rate thatmeans they have the appropriatereal interest rateon their investment.

This is given by the formula:

where:

= offered nominal interest rate

= desired real interest rate

= inflationary expectations
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Risk

The level ofriskin investments is taken into consideration. This is why veryvolatileinvestmentslikesharesandjunk bondshave higher returns than safer ones likegovernment bonds.

The extra interest charged on a risky investment is therisk premium. The required risk premiumis dependent on therisk preferencesof the lender.

If an investment is 50% likely to go bankrupt, arisk-neutrallender will require their returns todouble. So for an investment normally returning $100 they would require $200 back. Arisk-averselender would require more than $200 back and arisk-lovinglender less than $200.Evidence suggests that most lenders are in fact risk-averse.

Generally speaking a longer-term investment carries a maturity risk premium, because long-term loans are exposed to more risk of default during their duration.

[edit] Liquidity preference

Most investors prefer their money to be incashthan in lessfungibleinvestments. Cash is onhand to be spent immediately if the need arises, but some investments require time or effort totransfer into spendable form. This is known asliquidity preference. A 1-year loan, for instance,is very liquid compared to a 10-year loan. A 10-year USTreasury bond, however, is liquidbecause it can easily be sold on the market.

A market interest-rate model

A basic interest rate pricing model for an asset

Assuming perfect information, pe is the same for all participants in the market, and this isidentical to:

where

in is the nominal interest rate on a given investment

ir is the risk-free return to capital

i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills).

rp = a risk premium reflecting the length of the investment and the likelihood the borrower will

default

lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and

thus into goods).
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[edit] Interest rate notations

What is commonly referred to as the interest rate in the media is generally the rate offered onovernight deposits by the Central Bank or other authority, annualized.

The total interest on an investment depends on the timescale the interest is calculated on,because interest paid may becompounded.

Infinance, the effective interest rate is often derived from theyield, a composite measurewhich takes into account all payments of interest and capital from the investment.

Inretail finance, theannual percentage rateandeffective annual rateconcepts have beenintroduced to help consumers easily compare different products with different paymentstructures.

Interest rates in macroeconomics

[edit] Elasticity of substitution

The elasticity of substitution (full name should be the marginal rate of substitution of the relativeallocation) affects the real interest rate. The larger the magnitude of the elasticity of substitution,the more the exchange, and the lower the real interest rate.

[edit] Output and unemployment

Interest rates are the main determinant ofinvestmenton a macroeconomic scale. The currentthought is that if interest rates increase across the board, then investment decreases, causing a fall

innational income. However, theAustrian School of Economicssees higher rates as leading togreater investment in order to earn the interest to pay the depositors. Higher rates encouragemore saving and thus more investment and thus more jobs to increase production to increaseprofits. Higher rates also discourage economically unproductive lending such as consumer creditand mortgage lending. Also consumer credit tends to be used by consumers to buy importedproducts whereas business loans tend to be domestic and lead to more domestic job creation[and/or capital investment in machinery] in order to increase production to earn more profit.

A government institution, usually acentral bank, can lend money to financial institutions toinfluence their interest rates as the main tool ofmonetary policy. Usually central bank interestrates are lower than commercial interest rates since banks borrow money from the central bank

then lend the money at a higher rate to generate most of their profit.

By altering interest rates, the government institution is able to affect the interest rates faced byeveryone who wants to borrow money for economicinvestment. Investment can change rapidlyin response to changes in interest rates and the total output
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Open Market Operations in the United States

The effective federal funds rate in the US charted over more than half a century

[citation needed]

The Federal Reserve (often referred to as 'The Fed') implementsmonetary policylargely bytargeting thefederal funds rate. This is the rate that banks charge each other for overnight loansoffederal funds, which are the reserves held by banks at the Fed.Open market operationsareone tool within monetary policy implemented by the Federal Reserve to steer short-term interestrates. Using the power to buy and sell treasurysecurities.

[edit] Money and inflation

Loans, bonds, and shares have some of the characteristics of money and are included in thebroadmoneysupply.

By setting i*n, the government institution can affect the markets to alter the total of loans, bondsand shares issued. Generally speaking, a higher real interest rate reduces the broad moneysupply.

Through thequantity theory of money, increases in the money supply lead to inflation.

Negative interest rates

Nominal interest rates are normally positive, but not always. Given the alternative of holding

cash, and thus earning 0%, rather than lending it out, profit-seeking lenders will not lend below0%, as that will guarantee a loss, and a bank offering a negative deposit rate will find few takers,as savers will instead hold cash.[8]

However, central bank rates can, in fact, be negative; in July 2009 Sweden'sRiksbankwas thefirst central bank to use negative interest rates, lowering itsdeposit rateto0.25%, a policyadvocated by deputy governorLars E. O. Svensson.[9]This negative interest rate is possible
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because Swedish banks, as regulated companies, must hold these reserves with the centralbankthey do not have the option of holding cash[citation needed].

More often, real interest rates can be negative, when nominal interest rates are below inflation.When this is done via government policy (for example, via reserve requirements), this is deemed

financial repression, and was practiced by countries such as theUnited StatesandUnitedKingdomfollowing World War II (from 1945) until the late 1970s or early 1980s (during andfollowing thePostWorld War II economic expansion).[10][11]In the late 1970s,United StatesTreasury securitieswith negative real interest rates were deemed certificates of confiscation.[12]

Negative interest rates have been proposed in the past, notably in the late 19th century bySilvioGesell.[13]A negative interest rate can be described (as by Gesell) as a "tax on holding money";he proposed it as theFreigeld(free money) component of hisFreiwirtschaft(free economy)system. To prevent people from holding cash (and thus earning 0%), Gesell suggested issuingmoney for a limited duration, after which it must be exchanged for new billsattempts to holdmoney thus result in it expiring and becoming worthless. Along similar lines,John Maynard

Keynesapproving cited the idea of a carrying tax on money,

[13]

(1936, TheGeneral Theory ofEmployment, Interest and Money) but dismissed it due to administrative difficulties.[14]Morerecently, a carry tax on currency was proposed by aFederal Reserveemployee (MarvinGoodfriend) in 1999, to be implemented via magnetic strips on bills, deducting the carry taxupon deposit, with the tax based on how the bill had been held.[14]

It has been proposed that a negative interest rate can in principle be levied on existing papercurrency via aserial numberlottery: choosing a random number 0 to 9 and declaring that billswhose serial number end in that digit are worthless would yield a negative 10% interest rate, forinstance (choosing the last two digits would allow a negative 1% interest rate, and so forth). Thiswas proposed by an anonymous student ofN. Gregory Mankiw,[13]though more as a thought

experiment than a genuine proposal.

[15]
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Factors Influencing Interest RatesShareThis

comments

An interest rate is the amount received in relation to an amount loaned, generally expressed as aratio of dollars received per hundred dollars lent. However, a distinction should be made betweenspecific interest rates and interest rates in general. Specific interest rates on a particular financialinstrument (for example, a mortgage or bank certificate of deposit) reflect the time for which themoney is on loan, the risk that the money may not be repaid, and the current supply and demand inthe marketplace for funds available for lending.

Some specific rates, such as those onTreasuryorcorporate bonds, are set in dealer markets bynegotiations between buyers and sellers, and are called market rates. These rates are subject to

change daily. Other rates, such as the bankprime rate (which is the interest rate that banks chargetheir best customers) or the Federal Reserve discount rate (the rate at which banks can borrow fundsfrom the Federal Reserve) are set by some established group, and are known as administered rates.But these administered rates would not exist for very long if they didnt reflect some prevailingunderlying forces. Ultimately they reflect market rates.

There are a number of forces that must be taken into account when attempting to evaluate thecurrent and future movement of interest rates. To begin with, interest rates are strongly influenced bythe condition of the U.S.economy. When the economy is growing, consumers have jobs and savingsto lend through banks, but they must also borrow for large items, such as homes or cars, or to financeother purchases through credit cards. As the demand for funds increases, interest rates rise and act asa ration for the funds available. Of course, the opposite is also true; when the demand for funds islow, interest rates fall.

Inflationary pressures will also affect interest rates, because the rates paid on most loans are fixed inthe loan contract. A lender may be reluctant to lend money for any period of time if the purchasingpower of that money will be less when its repaid; the lender will, therefore, demand a higher rate(known as an inflationary premium). Thus, inflation pushes interest rates higher; deflation causes

rates to decline.

The actions of the federal governmenthave an effect on interest rates as well, because it is thenations largest borrower. The federal government has first claim on available funds in themarketplace. Because of its vast taxing powers and the strength of the U.S. economy, the federalgovernment has the highest credit rating and its debt is therefore a preferred investment.

International forces play an important role in influencing interest rates in the United States. To theextent that foreign investors are willing to lend money to the U.S., they supplement domestic sourcesof funds in the marketplace, driving interest rates down. If they were to decide to reduce or sell theirholdings in the U.S. and reinvest elsewhere, more needed funds would have to come from domesticsources, which would push rates upward.

The dollaris the main currency in international trade and is used extensively in world markets. Orderlyfluctuations of the dollar inforeign exchange marketsare essential for domestic and internationalstability. Major or very volatile exchange rate movements could force the Federal Reserve to act, aswell as affect interest rates and U.S. monetary policy.

Changes in the condition of the U.S. financial system will also have a significant effect on interestrates. If any large financial institution is threatened with collapse, it would not default on the fundswhich are owed to its depositors, as was the case in the 1930s. The federal government would takeaction to make good the deposits, regardless of the impact on the federal budget deficit. The Federal
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Reserve would open bank reserves as necessary, increasing the supply of funds in the market, andsending interest rates down, at least initially.

Its likely that the most important force to watch for evaluating future interest rate trends is theFederal Reserve. The Fed, as it is known, controls credit availability (in other words, the amount offunds available to lend) and the level of interest rates at which the funds are made available. Itsimportance in the operation of the financial system is beyond the scope of this article alone. Pleaseread the article seriesThe Federal Reservefor a more detailed discussion of this topic.

When interest rates change, it is the result of many complex

factors. People who study interest rates find that it is as

difficult to forecast future interest rates as it is the weather.

Since interest rates reflect human activity, a long-term

forecast is virtually impossible. After the fact, explanationsare many and confident! Some of the major factors which

help to dictate interest rates are explained below.

Supply and Demand for Funds

Interest rates are the price for borrowing money. Interest rates move up and down, reflecting manyfactors. The most important among these is the supply of funds, available for loans from lenders, andthe demand, from borrowers. For example, take the mortgage market. In a period when many people

are borrowing money to buy houses, banks and trust companies need to have the funds available tolend. They can get these from their own depositers. The banks pay 6% interest on five year GICs andcharge 8% interest on a five year mortgage. If the demand for borrowing is higher than the fundsthey have available, they can raise their rates or borrow money from other people by issuing bonds toinstitutions in the "wholesale market". The trouble is, this source of funds is more expensive.Therefore interest rates go up! If the banks and trust companies have lots of money to lend and thehousing market is slow, any borrower financing a house will get "special rate discounts" and thelenders will be very competitive, keeping rates low.

This happens in the fixed income markets as a whole. In a booming economy, many firms need to

borrow funds to expand their plants, finance inventories, and even acquire other firms. Consumersmight be buying cars and houses. These keep the "demand for capital" at a high level, and interestrates higher than they otherwise might be. Governments also borrow if they spend more money thanthey raise in taxes to finance their programs through "deficit financing". How governments spend theirmoney and finance is called "fiscal policy". A high level of government expenditure and borrowingmakes it hard for companies and individuals to borrow, this is called the "crowding out" effect.

Monetary Policy
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Another major factor in interest rate changes is the "monetary policy" of governments. If agovernment "loosens monetary policy", this means that it has "printed more money". Simply put, theCentral Bank creates more money by printing it. This makes interest rates lower, because moremoney is available to lenders and borrowers alike. If the supply of money is lowered, this "tightens"monetary policy and causes interest rates to rise. Governments alter the "money supply" to try andmanage the economy. The trouble is, no one is quite sure how much money is necessary and how it isactually used once it is available. This causes economists endless debate.

Inflation

Another very important factor isinflation. Investors want to preserve the "purchasing power" of theirmoney. If inflation is high and risks going higher, investors will need a higher interest rate to considerlending their money for more than the shortest term. After the very high inflation years of the 1970sand early 1980s, lenders had to receive a very high interest rate compared to inflation to lend theirmoney. As inflation dropped, investors then demanded lower rates as their expectations becomelower. Imagine the plight of the long-term bond investor in the high inflation period. After lendingmoney at 5-6%, inflation moved from the 2-3% range to above 12%! The investor was receiving 7%less than inflation, effectively reducing the investor's wealth in real terms by 7% each year!

What Factors Affect Interest Rates?By Prasanna Raghavendra, eHow Contributor| updated March 09, 2011

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When companies and individuals obtain loans from the market, they are required to pay interest onthe money borrowed. Lenders may compute interest rates differently. The interest rate could either

be a fixed rate or it could fluctuate with variations in the market. The interest rate is determined bytaking into account different factors like present market conditions, the state of the economy, theborrower's financial stability, length of the loan and the policies of the Federal Reserve.

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1. Inflation Rateso The inflation rate affects interest rates. When the loan is sought for a long period of time, the

lender needs to safeguard its interests. With the passage of time, the purchasing power ofthe currency goes down. Therefore, the lender would try to recover all the money lent bycharging an inflationary premium on the money lent.

Thus, inflation and the rate of interest have a direct relationship. When inflation rises, interestrates also rise.

2. Market Conditions
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o General market conditions have the ability to influence interest rates. When the generaltrends in the market are good, heavy trading takes place. For trading, investors need moneyand seek loans. As they know that they would be able to recover their money, they do notmind paying higher rates of interest on the loans. When market activities are sluggish,investors would be wary of trading heavily and hence the lenders would not be in a positionto charge high rates of interest.

Borrower's Financial Position

o The financial situation of the borrower has a bearing on interest rates. A more financiallystable borrower is able to obtain lower-rate loans. With such borrowers, there is very littlelikelihood of default, so lenders are willing to accept a lower return in exchange for less risk.When the lender assesses that the position of the borrower is not very sound, the lendercharges higher interest in line with the risks involved.

Length of the Loan

o The term of the loan and the rate of interest have a direct relationship. The shorter theduration of the loan, the lower the rate of interest. There is an element of uncertainty involvedin loans of longer duration. Therefore, the lenders charge higher interest rates for longer-term loans.

Federal Reserve

o The Federal Reserve can influence interest rates by setting the discount rate, the rate thatbanks pay for short-term loans from the Federal Reserve. It also can influence interest ratesby making changes to the money supply.

Read more:What Factors Affect Interest Rates? | eHow.comhttp://www.ehow.com/info_8041668_factors-affect-interest-rates.html#ixzz1mSr0848y

What Affects the Interest Rate?

By Katie Arcieri, eHow Contributor

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The Federal Reserve plays a key role in interest rates.The rise and fall of interest rates are affected by numerous factors including economic conditions,monetary policies and inflation. But perhaps the single biggest factor affecting interest ratefluctuations are decisions made by the Federal Reserve, which sets the overnight lending rate thatbanks charge each other. When the Federal Reserve lowers rates, consumers are able to borrowmoney cheaply and afford to buy big-ticket items more easily.

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1. Federal Reserve Impact on Interest Rates

o The Federal Reserve buys and sells securities like stocks, which causes the nation's money

supply to rise or fall.The Federal Reserve controls the ebb and flow of the nation's money provisions. It setspolicies that can increase or decrease money in banks by purchasing or selling securitiessuch as stocks, bonds and other financial instruments. When the Federal Reserve decides todecrease money, the interest rate that banks charge one another for overnight fundstumbles. That, in turn, causes lower interest rates on loans.

2. Inflation

o When consumers spend more money in the economy, retailers begin to jack up their pricesbecause there is more demand.

Inflation has a major impact on interest rates. When more money is pumped into theeconomy, banks have more funds to loan. As a result, interest rates descend. But whenconsumers spend more money, retailers jack up their prices. When that happens, consumersmay decide to hold back on their purchases.

3. Refinancing Boom
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o When interest rates fell in 2009, homeowners rushed to refinance to more favorable terms.

In response to the Great Recession that began in 2007, the Federal Reserve lowered

interest rates to combat a sluggish home market and inject liquidity into the market. Thehistorically low interest rates led to a refinancing boom in 2009 as homeowners sought morefavorable terms on their home loans. That's because interest rates fell dramatically after theFederal Reserve announced that it would buy up billions of dollars in mortgage-backedsecurities. Rates stayed fairly low in early 2010. The rate on a 30-year mortgage averaged5.21 percent during the week of April 8, 2010, up slightly from 5.08 percent the week prior,according to Freddie Mac.

4. Subprime mortgage crisis

o Many consumers locked themselves into subprime loans whose interest rates spiked down theroad.

Many critics blame the nation's subprime mortgage crisis on extremely low interest rates.With the cheap cost of money, consumers signed up for exotic subprime loans with lowinterest rates that would spike after a few years. When the interest rates on those loans didspike, consumers could not afford to keep their homes and were forced into foreclosure. As aresult, the home market flattened and home prices fell.

5. Fears of Government Default in Greece

o U.S. interest rates are risig amid fears of government default in Greece.

As of 2010, interest rates are rising amid fears of government default in Greece. Severalnations that use the euro for currency have agreed to bail out the Mediterranean country,whose stocks are falling in the midst of an economic recession. Experts expect U.S. interestrates to rise on everything from credit cards to cars.

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14/19

The Reasons That Interest Rates Rise andFall

By Colleen Reinhart, eHow Contributor

Print this article

Think of a loan as a commodity with a price.In the United States, interest rates on loans, credit cards and investments are affected by short-terminterest rate changes. According to "USA Today," the Federal Open Market Committee (FOMC), abranch of the Federal Reserve, adjusts short-term interest rates through panel voting. Theirdecisions have a trickle-down impact on all interest rates, impacting the cost of borrowing money.

Related Searches:

Inflation NRE Rates

1. Borrowing Money Has a Costo Just like a loaf of bread sold at a grocery store, a loan is a commodity with a cost. If

something happened to the world's wheat supply and the price of bread suddenly tripled,fewer people would buy bread because of its higher cost. When dealing with loans, the costof borrowing is the interest rate. When interest rates go up, getting a loan gets more

expensive, so fewer people choose to borrow money. The Federal Reserve manipulatesshort-term interest rates to moderate the effects of lending and consumer spending.

Controlling Inflation

o If interest rates weren't periodically adjusted, inflation would get out of control. Inflation is anincrease in the price of goods. Low interest rates cause people to borrow and to spend more,driving up the cost of products as there are more people with money and a desire to
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15/19

purchase than there are goods available for sale. A low, steady level of inflation is desirableand signals economic growth. Inflation that's too high, too low or generally unstable can havenegative effects on the economy. For example, creditors don't see a return on their loanswhen inflation soars higher than expected. If unusually high inflation causes the cost ofgoods to double over the course of a year but a creditor only charges a 20 percent interestrate on lent funds, then he lost money in real terms. The 100 percent jump in prices means

that the creditor could buy less than he could at the beginning of the year because the 20percent interest charged doesn't cover the change in the price of goods. Lowering interestrates makes loans less expensive, causing people to borrow more, buy more and push upprices. Raising interest rates has the opposite effect. Stable inflation rates reduce risk forboth borrowers and lenders, limit the cost to businesses of constantly repricing goods andhelp people living on fixed incomes to maintain a certain living standard.

Helping the Unemployed

o During a recession, lowering interest rates helps to stimulate the economy. When interestrates are lower, more businesses and government agencies can afford the loans they needto take on new projects. These new projects produce jobs, putting more cash back into the

pockets of consumers and lifting a sluggish economy out of a recession. Once more, peoplehave the money to spend again, and the FMOC has to increase rates closer to pre-recessionlevels to avoid inflation.

Other Effects of Interest Rate Hikes

o Long term, interest rate adjustments can affect the prices of stocks and other investments.The Federal Reserve notes that when interest rates are low, stocks have greater returnsthan bonds. Companies have more money to work with when interest rates are low, so stockbuyers expect higher profits and bid up prices. However, prices can become overinflated iflow interest rates make investors too optimistic. Interest rates also affect international

currency markets. Rising interest rates in a country promise higher investment returns forbuyers, so the relative value of the U.S. dollar tends to rise along with rates as investorspurchase more U.S. currency. The value of the dollar can affect international import andexport levels. Regulators have to watch the effects that rate policy is having on investmentsand trade to avoid a market crash or hardship for exporters.

How the Rate Is Decided and Applied Throughout theEconomy

o According to "USA Today," the FOMC consists of seven Board of Governors membersnominated by the president and confirmed by the Senate. The bank president of the Federal

Reserve of New York also gets a vote on the panel. Four other positions rotate among theremaining 11 regional Federal Reserve Bank presidents. The major banks adjust their primerates based on FOMC announcements. If the FOMC raises rates and the major banks leavetheir lending rates unchanged, the banks see less profit. The FOMC meets to adjust rateseight times a year, with jurisdiction to change rates more often during emergencies.

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16/19

The Effects of Interest Rates on theEconomy

By Edwin Thomas, eHow Contributor

Print this article

Interest rates have many direct and indirect effects on the economy. Many of these effects aredescribed under the umbrella of monetary policy, and the few that are not are the product ofgovernment fiscal policy. Therefore, the interaction of interest rates and the economy can be tracedback either to the Federal Reserve or the federal budget.

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Monetary Policy 6 Month CD Interest Rates

1. Monetary Policyo Monetary policy is the means by which the Federal Reserve uses the supply of money and

the cost of borrowing money to regulate the economy. The cost of borrowing money is betterknown as interest rate. While the interest rates set by the Federal Reserve are not the sameas the interest rates people pay on their credit cards and home mortgages, they are related.

Expansionary Policy

o Expansionist monetary policy is aimed at expanding credit and the money supply. It is acommon tool for combating recessions, but it has been broadly the standing monetary policyof the United States since the mid-1980s, when the economic malaise known as "stagflation"was tamed. The Federal Reserve has three mechanisms for expanding the money supply.First, it can can increase the actual, real money supply. This is done not by printing money (afunction of the Treasury), but by buying up bonds. Buying bonds dumps hard currency intothe open market. A second tool is to reduce the reserve requirements of banks. This is theamount of capital a bank is required to keep on hand, so lowering it means they can loan outmore of its capital. The third tool is to lower the discount and Federal funds rate, which is theinterest charged on the short-term loans made by the Federal Reserve or between banks to

meet reserve requirements.

Contractionary Policy

o Contractionary monetary policy means contracting the availability of credit and/or the moneysupply. The Federal Reserve does this using the same tools, only in reverse: raising reserverequirements, raising interest rates and selling off bonds to soak cash out of circulation. The
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17/19

classical target of a contractionary policy is to fight inflation, which was the standing policy ofthe Federal Reserve under Paul Volcker in the late 1970s to the mid-1980s.

Examples of Monetary Policy in Action

o Paul Volcker's contractionary policy is widely credited with taming the 1970s demon ofstagnant economic growth and high inflation known as "stagflation." Inflation hit a 1981 highof 13.5 percent, but had dropped to 3.5 percent by 1983, and was below 2 percent for muchof the 1990s. Volcker raised the interest rates under his control to above 20 percent, whichcaused a severe recession, practically strangling both the construction and agriculturalsectors. However, the results tamed inflation and set the stage for the more prosperouseconomic conditions enjoyed over the next 20 years.

His successor, Alan Greenspan, pursued a mixed expansionary-contractionary policy. Whilebroadly speaking, the period between the mid-1980s and the early years of the 21st centurywere expansionary in nature, with easy credit being encouraged, Greenspan had a tightpolicy in the late 1980s to act as a counterweight to the Federal deficit, and raised interestrates several times in 2000 with an eye on keeping a lid on inflation and deflating the

speculative bubble in the stock market, particularly the tech sector.

Greenspan responded to the 2001 recession with a markedly expansionist monetary policy,which was continued by his successor Ben Bernake. This very loose, expansionist policy hasbeen blamed for the reckless lending that characterized the credit crisis and global recessionof 2007 to 2009.

Fiscal Policy and Interest Rates

o A different set of interest rates that effect the economy is the interest rates offered by theU.S. Treasury on bonds and other debt instruments. These interest rates must be sufficientto attract investors and their money, or the government will be unable to raise the cash to

cover budget deficits. The more money the government needs to borrow, the higher theinterest offered on government bonds needs to be, and therefore the more expensive thatdebt becomes. Expensive debt limits future government spending options, with a directimpact on the U.S. economy. Also, the interest offered on government debt has an indirecteffect on trade relations, as foreign governments often buy up public debt to get negotiatingleverage on the U.S. government. This was the practice of the Japanese in the 1980s, andthe Chinese in the early part of the 21st century. By buying up cheap debt, thosegovernments were able to force trade settlements that were advantageous to them, lest thegovernment lose an important creditor and be forced to raise interest rates to compensate.That has a direct impact on American jobs.

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18/19

RBI likely to pause hike in interest rate

PTI

Last Updated : 15 Dec 2011

MUMBAI: Amid declining growth and moderating inflation, the Reserve Bank of India (RBI) is

likely to pause hike in interest rate at the mid-quarterly review of the monetary policy tomorrow.

RBI, which has raised interest rate 13 times since March, 2010 to tame inflation, may change the tight

monetary stance as the industrial production has turned negative in October recording a fall of 5.1 per

cent.

As regards price situation, although the headline inflation has remained close to double-digit mark in

November, there are signs of moderation. The food inflation, according to the data released today, fell

to a nearly four-year low of 4.35 per cent during the week ended December 3.

The RBI in its mid-year policy in October had indicated that it might halt rise in interest rate if the

inflationary situation does not worsen.

The bigger worry on the economic at this time is to arrest falling growth.

"Domestically, the struggle against inflation and tightening interest rate regime has contributed to

lowering of growth in demand and investment. The slowdown in industrial growth is of particular

concern as it impacts employment," Finance Minister Pranab Mukherjee said in New Delhi.
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19/19

State Bank of India Chairman Pratip Chaudhuri had said yesterday the he did not expect the RBI to hike

interest rate in its next policy.

"I don't think so because food inflation has come down significantly and steadily. RBI has said 7 per cent

is the level they are targeting", he told the reporters.

Besides, other experts and economists too are of opinion that RBI would pause hike in interest ratebecause of economic slowdown and decline in rate of price rise.

Chaudhuri added, however, that he does not expect RBI to slash the Cash Reserve Ratio (CRR) as it

would be contradictory to the monetary stance of targeting inflation.

ICRA Economist Aditi Nayar said RBI is likely to keep the rates unchanged because though food inflation

has fallen, manufactured products inflation still remains at an elevated level of 7.7 per cent.

"With inflation related to non-food manufactured products rising in November, 2011, RBI is expected to

leave the repo rate and the CRR unchanged in the upcoming mid-quarter policy to continue to dampen

inflationary expectations," she said.

The country's GDP expanded by a meagre 6.9 per cent in the second quarter of the current fiscal, the

lowest in over two years. India Inc has blamed the rate hikes, which have increased the cost of

borrowings, for hindering fresh investments and slowdown in industrial activity.

"We think the RBI will go for a pause. It is still too early to reverse the rates. Manufactured inflation still

remain above 7 per cent and is likely to remain high as rupee depreciation has made imports expensive.

"We expect rate cuts to come in the first quarter of 2012," Crisil Chief Economist D K Joshi said.

Industry bodies like CII and Ficci have already called upon the RBI to cut rates for ensuring industrial

revival.

According to Goldman Sachs, the negative growth in IIP numbers increases the probability of an earlyreserve requirement cut by RBI.

"Our current expectation remains that the RBI will continue to inject liquidity through open market

operations, then cut the reserve requirement ratios of banks in January, followed by repo rate cuts in

March, 2012. We continue to expect the RBI to cut policy rates by an above-consensus 150 bp in 2012,"

Goldman Sachs said in a report.

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