interest rates and inflation

Topics: Inflation, Central bank, Federal Reserve System Pages: 8 (2835 words) Published: April 1, 2014
The Interest Rate
Essentially, interest is nothing more than the cost someone pays for the use of someone else's money.  The interest rate that applies to investors is the Federal Reserve's federal funds rate. This is the cost that banks are charged for borrowing money from Federal Reserve banks. Why is this number so important? It is the way the Federal Reserve (the "Fed") attempts to control inflation. Inflation is caused by too much money chasing too few goods (or too much demand for too little supply), which causes prices to increase. By influencing the amount of money available for purchasing goods, the Fed can control inflation. Other countries' central banks do the same thing for the same reason.

Basically, by increasing the federal funds rate, the Fed attempts to lower the supply of money by making it more expensive to obtain. Interest Rates and Investors
Investors can choose to invest in stocks or bonds, and their investment choice is based on the expected returns of each investment. For example, suppose that the Fed decides to lower interest rates. When interest rates are lowered, bonds are issued with a lower interest rate. As a result, investors will realize they can earn more money by investing in stocks, and they will do so. When more people choose to invest in stocks, stock prices will start to rise. Similarly, when the Fed decides to raise interest rates, bonds will be issued with a much higher interest rate. This will encourage investors to purchase bonds, and as investors sell their stocks, stock prices will fall. Interest Rates and Consumers

When the Fed decides to lower interest rates, consumers are encouraged to purchase items such as houses and cars because they can finance these purchases at lower interest rates. As consumers start to spend, they increase the earnings of companies. As investors notice the earnings of a company start to increase, they will purchase shares in the company and this will cause the stock price to rise. Similarly, if interest rates rise, consumers save their money. As consumers save, business earnings decrease. As investors see a decrease in business earnings, they sell stocks and stock prices fall. Interest Rates and Businesses

When the Fed lowers interest rates, it decreases the cost of investing for businesses. Businesses start to expand and invest in more projects because investing is profitable. As a business starts to expand, investors purchase stock in the hopes of being able to sell in the future at a higher price. The increased purchase of stock causes stock prices to rise. Similarly, if the Fed decides to raise interest rates, a business will hold back on investing as it realizes that investing is less profitable due to the increased cost to invest. As investors notice decreased business investment, they assume the economy is starting to decline and sell their stocks, which causes stock prices to fall. WHY SHOULD YOU KNOW ABOUT INTEREST RATES?

Interest Rate in simple words means the cost of borrowing funds. It is the payment we make to the lender for the facility of using his money for our own purpose. Many times our spending decisions are also guided by the interest burden that we would be bearing.

But, more than the returns we should be concentrating on real returns on our savings (real return = interest rate- inflation). The ‘real returns’ concept has been already discussed in our previous article titled ‘Inflation’. Even as consumers, interest rate is an integral part of our spending habit as we borrow from the bank for buying house, cars, house old items etc. For the business community interest rate is also very important as they borrow money from bank for investment activities like capacity expansion, setting up of plants, acquisitions, modernization etc. So interest rates play a critical role in a business’s profitability and hence, on stock prices. INTEREST RATES DECIDE WHERE WE INVEST.

How many of us would invest in stock markets if our bank...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Essay about Relationship between Inflation and Interest Rate
  • Inflation Rates and Interest Rates (Mankiw) Essay
  • Essay on Effects of Changes of Interest Rates & Inflation
  • • Interest Rate, Inflation, Earnings and the Market. Essay
  • inflation Essay
  • Term Structure of Interest Rate Essay
  • Interest Rates Essay
  • Inflation Rate Essay

Become a StudyMode Member

Sign Up - It's Free