Interest Rates.....
Ok, as I had promised, I shall present to you another major economic issue that is ongoing -- interest rates. I shall attempt to present a brief overview of the roles of interest rates as well as my own views on the recent rise in interest rates by the US Federal Reserves.
To most of us common folks, the interest rate is what you will stand to gain if you put your money in the bank as well as how much more you have to pay back when you borrow money from the bank. Hence, depositors/creditors will love it when the interest rates rise while debtors/borrowers prefer the interest rates (i/r) to decline. Yet, because of this basic mindset which most people tend to have, the effects of a change in interest rates are humongous.
To economists, i/r are a valuable tool in ensuring macro-economic stability. The way it works is pretty simple. When there is a shortage in demand in the economy, lowering the i/r will help to boost both Consumption (C) and Investment (I) spending. For countries which have a floating exchange regime, the lowering of interest rates will then lead to an outflow of foreign capital, which causes the currency to depreciates and eventually boost Exports (X) while people adopt a strategy of Imports (I)-Substition. So based on the classicals model, Aggregate Demand(AD) will rise. Likewise if the government feels that inflationary pressures are building up, they will raise interest rates so as to reduce AD and hence prevent the economy from over-heating.(There isn't much use to examine the effects of i/r on economies with a fixed exchange regime since they clash. You can check this out with any A-Level Economics student about the reasons behind it.)
Ok, the above is what every A-level Economics student knows, and many have mug it like mad. However, the whole story doesn't stop here. I believe that i/r acts more of a signal to people as to how they ought to behave. The above idea of i/r effects on the economy are certainly valid, but they do not explain the whole picture, especially when you combine them with the role of expectations. Now, usually i/r is a tool to achieve the ends -- which can be to reduce unemployment or to achieve greater growth rates. In the case of unemployment, the concepts of NAIRU as well as Lucas Rational Expectations clearly shows that only demand-shocks are capable of causing a change in real income (this point is still very very much debated). Likewise, i/r can stimulate rapid growth, but empirical studies have shown that it can lead to inflationary pressures which might boost inflation (many consider excessive inflation as bad, and so do I). In my views, changes in i/r only function properly if people's expectations are in-lined with it, or that the change in i/r will not create other even more serious problems.
Therefore, this means that a sudden change in i/r will have a huge effect on the economy if it is totally unexpected. For example, I believe the 0.25% increase in i/r by the US will have little effect on the current state of the economy (although it might curb some inflation). This view has been echoed by many (even showing up on the New Paper). Certainly, I doubt the rise in i/r will affect much of the US or even the rest of the world. For the case of Singapore, you might expect our interest rates to rise (by just 0.1%?), but on the whole its insignificant as everyone has already expected it. Likewise, the US Fed Reserves will most likely do a gradual increase in i/r and hence slowly keep inflation in check. As the economy gradually experiences a rise in i/r, you can expect excessive spending on our part to reduce while savings to rise.
The other effect of a rise in i/r (its hard to decide causality here) is that people might assume that the economy is peaking out and its time to invest more. This might have a disastrous effect on inflation, yet conducive for growth. But few will make such a mistake. Anyway, I have missed up on the impact of i/r on financial markets. Personally, I feel that the stock market will experience a rise until the i/r hits close to 4%, and then maybe the market will stabilise. Personally, I feel that by early next year, in lieu of the global recovery, the US Fed Reserves will raise i/r to around 2%. Of course this is not absolute, as it is still dependent on whether other shocks come along the way.
I admit I have neglected some other ideas which I love (rules vs discretion, Keynesian vs Monetarist vs neoClassicals), as it requires too much time. I'm a rush to do things now, since I'm paying a visit to the temple. Oh yea, I won't blog next week so expect to hear from me only next next week (if I go home). So I guess all of you who are freaking out at my long posts will have peace for a long time!
To most of us common folks, the interest rate is what you will stand to gain if you put your money in the bank as well as how much more you have to pay back when you borrow money from the bank. Hence, depositors/creditors will love it when the interest rates rise while debtors/borrowers prefer the interest rates (i/r) to decline. Yet, because of this basic mindset which most people tend to have, the effects of a change in interest rates are humongous.
To economists, i/r are a valuable tool in ensuring macro-economic stability. The way it works is pretty simple. When there is a shortage in demand in the economy, lowering the i/r will help to boost both Consumption (C) and Investment (I) spending. For countries which have a floating exchange regime, the lowering of interest rates will then lead to an outflow of foreign capital, which causes the currency to depreciates and eventually boost Exports (X) while people adopt a strategy of Imports (I)-Substition. So based on the classicals model, Aggregate Demand(AD) will rise. Likewise if the government feels that inflationary pressures are building up, they will raise interest rates so as to reduce AD and hence prevent the economy from over-heating.(There isn't much use to examine the effects of i/r on economies with a fixed exchange regime since they clash. You can check this out with any A-Level Economics student about the reasons behind it.)
Ok, the above is what every A-level Economics student knows, and many have mug it like mad. However, the whole story doesn't stop here. I believe that i/r acts more of a signal to people as to how they ought to behave. The above idea of i/r effects on the economy are certainly valid, but they do not explain the whole picture, especially when you combine them with the role of expectations. Now, usually i/r is a tool to achieve the ends -- which can be to reduce unemployment or to achieve greater growth rates. In the case of unemployment, the concepts of NAIRU as well as Lucas Rational Expectations clearly shows that only demand-shocks are capable of causing a change in real income (this point is still very very much debated). Likewise, i/r can stimulate rapid growth, but empirical studies have shown that it can lead to inflationary pressures which might boost inflation (many consider excessive inflation as bad, and so do I). In my views, changes in i/r only function properly if people's expectations are in-lined with it, or that the change in i/r will not create other even more serious problems.
Therefore, this means that a sudden change in i/r will have a huge effect on the economy if it is totally unexpected. For example, I believe the 0.25% increase in i/r by the US will have little effect on the current state of the economy (although it might curb some inflation). This view has been echoed by many (even showing up on the New Paper). Certainly, I doubt the rise in i/r will affect much of the US or even the rest of the world. For the case of Singapore, you might expect our interest rates to rise (by just 0.1%?), but on the whole its insignificant as everyone has already expected it. Likewise, the US Fed Reserves will most likely do a gradual increase in i/r and hence slowly keep inflation in check. As the economy gradually experiences a rise in i/r, you can expect excessive spending on our part to reduce while savings to rise.
The other effect of a rise in i/r (its hard to decide causality here) is that people might assume that the economy is peaking out and its time to invest more. This might have a disastrous effect on inflation, yet conducive for growth. But few will make such a mistake. Anyway, I have missed up on the impact of i/r on financial markets. Personally, I feel that the stock market will experience a rise until the i/r hits close to 4%, and then maybe the market will stabilise. Personally, I feel that by early next year, in lieu of the global recovery, the US Fed Reserves will raise i/r to around 2%. Of course this is not absolute, as it is still dependent on whether other shocks come along the way.
I admit I have neglected some other ideas which I love (rules vs discretion, Keynesian vs Monetarist vs neoClassicals), as it requires too much time. I'm a rush to do things now, since I'm paying a visit to the temple. Oh yea, I won't blog next week so expect to hear from me only next next week (if I go home). So I guess all of you who are freaking out at my long posts will have peace for a long time!
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