A short refReshEr on Interest rateS.....
Ok, I shall recap on my interest rates post because I realised how crappy I was. I guess I need to iron out certain issues about interest rates and some of the opinions I have about them.
Firstly, let me discuss about the impacts of interest rates on both the assets market and the Foreign exhange (Forex). Now, as interest rates rise, other assets will look less valuable as the rate of return on cash is now higher than before, hence people will switch to money. In this case, there will be a reduction in demand for housing, shares, stocks and bonds (the famous inverse relationship between price of bonds and interest rates does play a part). Similarly, you can also view that a rise in interest rates will make investment by companies less profitable, and hence a decline in stocks and share prices. A rise in interest rates will also curb consumer spending as previously mentioned.
On the forex side, a rise in interest rates will lead to an increase in hot money in the economy, causing the value of the currency to rise and hence increase real wages. This rise will then lead to more imports and a reduction in exports which curb domestic demand and hence inflationary pressures. However, it will distort the country’s current account and cause it to possibly go into the red.
Now, as you can see, what I have illustrated above are the possible effects of changes in i/r If we consider this in the case of the US economy, the recent rise has not really caused much changes (on both wall street and trade). I have already mentioned about the role of expectations in the whole picture, but I’ve recently read this article in the Economist which lambasted the Fed Reserves for even bothering to lower i/r and cushion the slump, instead of letting the whole economy to readjust itself and iron out all its faults. I must agree with him to some extent that by considering cushioning the economy, you might not solve some of the inherent faults in the system and this can caused a even bigger slump just like Japan. Anyway, it is amazing how much the US economy actually mirrors that of Japan’s in the past. Let’s pray that the lost decade of Japan in the 90s will not occur to US in future (but I doubt it). Anyway, I think the 0.25% rise is more of a signal, and not just an end.
This brings me to the point about tools and targets. I am a pretty firm believable that i/r is just a tool for you to control growth, inflation and employment plus Balance of Payments (BOP). But I care more for the first 3 as I believe that growth will be what affects the standard of living for people, inflation will affect the proper functioning of the economic system while employment will affect the society as well as the amount of resources that people get to enjoy at a period in time. So, i/r is what I will consider as the more important economic tool (better than fiscal measures certainly). Of course, we must not neglect that the government does play a huge role as well in affecting the 3 above goals.
Hope I clarify some doubts and I’ve hope I got my point across strongly. =)
Firstly, let me discuss about the impacts of interest rates on both the assets market and the Foreign exhange (Forex). Now, as interest rates rise, other assets will look less valuable as the rate of return on cash is now higher than before, hence people will switch to money. In this case, there will be a reduction in demand for housing, shares, stocks and bonds (the famous inverse relationship between price of bonds and interest rates does play a part). Similarly, you can also view that a rise in interest rates will make investment by companies less profitable, and hence a decline in stocks and share prices. A rise in interest rates will also curb consumer spending as previously mentioned.
On the forex side, a rise in interest rates will lead to an increase in hot money in the economy, causing the value of the currency to rise and hence increase real wages. This rise will then lead to more imports and a reduction in exports which curb domestic demand and hence inflationary pressures. However, it will distort the country’s current account and cause it to possibly go into the red.
Now, as you can see, what I have illustrated above are the possible effects of changes in i/r If we consider this in the case of the US economy, the recent rise has not really caused much changes (on both wall street and trade). I have already mentioned about the role of expectations in the whole picture, but I’ve recently read this article in the Economist which lambasted the Fed Reserves for even bothering to lower i/r and cushion the slump, instead of letting the whole economy to readjust itself and iron out all its faults. I must agree with him to some extent that by considering cushioning the economy, you might not solve some of the inherent faults in the system and this can caused a even bigger slump just like Japan. Anyway, it is amazing how much the US economy actually mirrors that of Japan’s in the past. Let’s pray that the lost decade of Japan in the 90s will not occur to US in future (but I doubt it). Anyway, I think the 0.25% rise is more of a signal, and not just an end.
This brings me to the point about tools and targets. I am a pretty firm believable that i/r is just a tool for you to control growth, inflation and employment plus Balance of Payments (BOP). But I care more for the first 3 as I believe that growth will be what affects the standard of living for people, inflation will affect the proper functioning of the economic system while employment will affect the society as well as the amount of resources that people get to enjoy at a period in time. So, i/r is what I will consider as the more important economic tool (better than fiscal measures certainly). Of course, we must not neglect that the government does play a huge role as well in affecting the 3 above goals.
Hope I clarify some doubts and I’ve hope I got my point across strongly. =)
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