Interest Rates Philosophy

Interest Rate Philosophy


SylvesterJoseph Maina

University of Nairobi

30th December 30, 2014.












Interest Rate Philosophy
Introduction
The future of the economy is tightly controlled by the Federal
Reserve (the Fed) through dictating interest rates. The capital budgeting
decisions fundamentally relies on interest rates tied to reality. These
interest rates link actual savings to funds that can be loaned. The current
versus the later decisions encompass a discounting of prospective cash
flows using interest rates that work as a reference. The rationale for
building a processing plant, starting a business or not ultimately depends
on the particular interest rate at which the starting capital can be
borrowed. There are various philosophies that seek to unravel the mystery
that is the effects of interest rate changes on the consumer. Despite the
different ways that explain how consumers are affected, it is almost
universal that interest rates have significant impacts on how consumers
spend, save and invest their income. Interest rates also determine whether
or not a consumer will request for a loan from a lending institution.
Hypothesis
The conventional economic school of thought traditionally held that a
state of symmetry existed in the economy. The rationale was that due to the
belief that the consumer is always greater compared to the producers to
meet the needs of the consumer, anything that is offered will subsequently
be consumed if the suitable price is arrived at. The Keynesian approach at
some point overturned the mainstream thinking. Keyne viewed the economy as
incapable of sustaining itself at complete employment. He held that it was
essential for the authorities to intervene and bring to use the under-
utilized savings to function through government spending. As such, the
theorist held that the cure to financial depressions is the stimulation of
the economy by governments. Among the suggested approaches to solving
financial depressions is the reduction of interest rates through the
monetary policy.
Consumers are the victims of changes in interest rates. The reduction
of interest rates at which the lender bank lends finance to other banks
communicates a strong message to commercial banks to exercise the same to
the consumer. The Fed often steps in through the federal government
investment in infrastructures. These infrastructures come in form of
treasuries and bonds. The move creates economic opportunity through the
reversal of the effects of demand imbalances.
Literature review
More often than not, interest rates in the view of capitalism are
perceived to work out in times of self-adjustment and growth during short-
lived recessions of a pro-supply financial environment. However, analysis
indicates these assertions are well beyond containing long recessions or
marginal economic surroundings. The government interference in the national
economical during the last economic recession was targeted at ensuring the
salvation of the financial structures. The financial structures are
inherently unable to adjust to a surrounding that utilizes comparatively
high interest lending.
The essential consumers who wish to borrow more but their access to
loans is limited by access to credit are anticipated to be insensitive to
the interest rates and costs of borrowing. The sensitivity to interest
rates compare to the demand for borrowing can be easily estimated at the
extensive margin i.e. when the interest rates increase, the take up for
loans is anticipated to reduce for unconstrained consumers. It has been
observed that for constrained consumers, interest rate is not a significant
determinant for their loan uptake. However, individuals who can afford to
meet their needs using other means are sensitive to interest rates. They
will most likely take loans to meet their needs when interest rates are
low. When the interest rates increases, they will forfeit the loans and opt
to pursue other forms of funding for their ventures. They may also put on
hold some projects that are not urgent, waiting for the interest rates to
be reduced so that they can realize maximum benefits from investments made
through loan
Durable goods include housing investments, vehicles, household items,
and entertainment goods. Reduction in interest rates on durable goods
resulted in an increase in durable goods purchases during the initial four
years of recovery from a financial crisis. However, in the first four years
of present recovery, reduction in interest rates have not resulted in
significant effect on durable goods acquisitions. The argument seeking to
explain the anomaly is that small-scale consumers are not interested in
purchasing durable goods while large-scale earners do not consider increase
in interest rates when purchasing.
Typically, financial institutions borrow short and lend long. These
institutions borrow by taking demand deposits. These include savings and
checking deposits that must be paid back to the depositor when they demand.
On the other hand, the money the banks lend to borrowers is attached to
long-term loans such as home investments. Considering that long-term
interest rates at which these institutions lend and the short-term interest
rates at which the banks borrow may fluctuate, the institution run the risk
of losing the money if unforeseen differences between the two emerges.
Consequently, they require effective management of any potential exposures
the banks have to interest rate risks (Gu & Huang, 2013).
Discussion
Those who advocate for the setting of interest rate ceiling fail to
understand or mistrust the strong pricing discipline enforced on lenders in
the inherently competitive credit industry where other sources of credit
are available in plenty. Increasing interest rates at times make borrowers
to abandon their repayment obligation. This realization has resulted in the
emergence of advocates of credit restrictions. They understand the lending
market well enough. Consequently, they support curtailing of credit supply
under strict interest rate ceiling as a way of 'saving the credit consumers
from themselves'. It also saves societies and neighborhoods from the costs
of personal financial failures and the consequent bailouts (Lee, 2010).
Whereas those legislations play a central role in the protection of
consumers with loans, they also contribute to the reduction of the number
of potential consumers who can borrow from the lending institutions.
Consequently, the wealth gap between those who meets the criteria to borrow
and their incapable counterparts increases. The situation is worsened by
loan contract terms and other credit collection practices. The legislations
on credit ceilings have equally same detrimental impacts on the supply of
credit. However, when these policies are well articulated before they are
enacted, they can ably facilitate the increase of credit demand. In the
contemporary credit market, these regulations are of particular interest
and are relevant as legislations proliferate at the state and federal
levels with the aim of offering protection to credit cards and mortgage
product consumers.
It is essential to acknowledge that even though these regulations
play a key role in addressing credit consumers, they also inflict varying
degrees of costs on creditors. Consequently, they inevitably decrease the
supply of the product under regulation. Therefore, policymakers seeking to
help consumers require to recognize the tradeoff. Increasing interest rates
at times make borrowers to abandon their repayment obligation. This
realization has resulted in the emergence of advocates of credit
restrictions. They understand the lending market well enough. Consequently,
they support curtailing of credit supply under strict interest rate ceiling
as a way of 'saving the credit consumers from themselves'. It also saves
societies and neighborhoods from the costs of personal financial failures
and the consequent bailouts
When the consumer pays lower interest rates, it offers them more
money to spend. The effect is not only felt by the consumer but also the
whole economy. There is a ripple effect that is experience in the economy.
Changes in interest rates also have substantial impacts on recession and
inflation. When the rates are falling or rising, the federal fund rate
comes into mind. This is actually the rates at which lending institutions
lend money to each other.
Conclusion
The Fed's financial policy impacts real economic activity
fundamentally through the control of interest rates for end users and
commerce. The diluted effect of reduced interest rates on end user
expenditure has consequently diminished the efficacy of financial policy in
the ongoing upturn. The possession of physical capital or government bonds
illustrates a claim to a sequence of upcoming payments, which is mainly
unaltered by a variance in interest rates. The philosophy on how interest
rates are perceived by the general public is almost universal that the Fed
has far-reaching effects on the consequences of the alteration of interest
rates. It is imperative for policy makers and philosophers to research into
the existing effects of interest rates on consumers and consequently the
global economy.
















References
Gu, L., & Huang, D. (2013).Consumption, Money, Intratemporal Substitution
and Cross-Sectional Asset Returns. Journal of Financial Research,
36,115 –146.
Lee, J. (2010). U.S. Consumption after the 2008 Crisis. International
Monetary Fund, IMF Staff Position Note, January 15.