CONTENTS

Executive Summary------------------------------
Introduction----------------------------------------
Interest Rates---------------------------------------
Government Increases Interest Rates------------
Effects Of Increased Interest Rates----------------
Increase In Interest Rates Bring Economic Prosperity--------
Inflationary Cycle----------------------------------------------
Interview of Dr Shamshad Akhter--------------------------------
Answers to the Questions-------------------------------------------
Conclusion---------------------------------------------------------------
Bibliography-------------------------------------------------------------
 Introduction

Interest is a fee, paid on borrowed capital. Assets lent include money, shares,
consumer goods through hire purchase, major assets such as aircraft, and
even entire factories in finance lease arrangements. The interest is calculated
upon the value of the assets in the same manner as upon money. Interest can
be thought of as "rent on money". For example, if you want to borrow money
from the bank, there is a certain rate you have to pay according to how much
you want loaned to you.

The fee is compensation to the lender for foregoing other useful investments
that could have been made with the loaned money. Instead of the lender using
the assets directly, they are advanced to the borrower. The borrower then
enjoys the benefit of using the assets ahead of the effort required to obtain
them, while the lender enjoys the benefit of the fee paid by the borrower for the
privilege. The amount lent, or the value of the assets lent, is called the
principal. This principal value is held by the borrower on credit. Interest is
therefore the price of credit, not the price of money as it is commonly - and
mistakenly - believed to be. The percentage of the principal that is paid as a fee
(the interest), over a certain period of time, is called the interest rate.

The interest rate is the profit over time due to financial instruments. In a loan
structure whatsoever, the interest rate is the difference (in percentage) between
money paid back and money got earlier, keeping into account the amount of
time that elapsed. If you were given 100$ and you give back 120$ after a year,
the interest rate you paid was 20% a year.

Nominal interest rate are laid down in contracts between involved parties. Real
interest rates somehow ajust the nominal ones to keep inflation into account.
For instance if inflation was 15%, in the previous example the real interest rate
can be said to be 20%-15% = 5%, in a simplified way of computation.

Interest rates change on a regular basis. The rates that you pay on a mortgage
or other type of loan will vary from day-to-day and week-to-week based on
many macroeconomic variables, including inflation, unemployment rates,
growth rates, tax laws, and the Fed's policies and outlook. The Fed affects
interest rates by setting two key rates, the discount rate and the federal funds
rate. The discount rate is the rate which the Federal Reserve Bank charges its
member banks for overnight loans. The Fed actually controls this rate directly,
but it tends to have little impact on the activities of banks because these funds
are also available elsewhere.
The federal funds rate is the interest rate at which banks loan excess reserves
to each other. While the Fed can't directly affect this rate, it effectively controls
it in the way it buys and sells Treasuries to banks. This is the rate that reaches
individual investors, though the changes usually aren't felt for a period of time

Rates types

There exist several nominal interest rates, depending on the following elements:

1. The institution offering the credit

2. The organization receiving the loan, which can be more or less

trustworthy;

3. The funds' use and the aims of the financed plan (consumption,
investment, working capital,...);

4. The time length of the loan with the broad difference between short-term
interest rate and long-term interest rate;

5. The ex-ante flexibility of the contract with the alternative between a fixed
interest rate or a variable interest rate;

6. The number, the frequency and the amounts of reinbursement actions;

7. The conditions under which the loan is agreed, for example regarding
guarantees and collateral;

8. The presence or absence of a market for converting loan conditions and

for changing the parties involved in the contract.

For instance, the fixed interest rate paid to a bank by private firms for
financing an industrial investment, characterized by a payback period of 3-7
years, exerts a crucial importance in the economy. In fact, it may influence
overall investment, thus the business cycle.

As the typical lending institution, the bank finances its credit activity in
several ways:

1. By collecting money from households deposits (and pay to them an interest

rate on deposits),

2. By issuing its own obligations, characterized by a bonds interest rate,

3. By taking short-term loans from other banks, paying the inter-banking
interest rate,

4. By borrowing money from the central bank, this requires an interest rate for
refinancing operations.

When establishing the interest rate to the public, banks all over the world
make reference to these rates (e.g. "1.5% more than EURIBOR" - the famous
interbank interest rate for loans in euros).

If the firm is a sound primary firm with excellent trustworthiness, the bank
would agree an interest rate only slightly higher than the rate the same bank
would be requested to pay in the inter banking market from other lending
institutions. By contrast, for smaller industrial firms, the rate usually would be
significantly higher because of the worsened credit risk.

Apart from bank loans, a key interest rate in the economy is that paid on
Treasury bonds. Similarly, private, public and state-owned firms issue bonds
as well, expressing further nominal interest rates.

Both state and firm bonds can be continuously exchanged in public markets,
making their effective interest rate dependent on the price at which it has been
bought. A bond, whose nominal price is 100 and interest rate is 5%, will in
reality give a 10% yield if it is bought at a price of 50 in the public market.

Households receive interests on their bank accounts; usually higher if they

block money for a certain period (savings account) and lower if it is an "a vista"
account (current account).

Conversely, households pay an interest when taking loans for consumption

purposes.

The following picture summarizes most of what we said, with an arrow for each
kind of interest rate:

 
 

Many other interest rates could be found on the light of the fact that any
negotiation can produce a specific rate.

In term of comparison among their mutual relationships, in some cases it is

known which rate is higher and which is lower but differences (the so-called
"spread" between two rates) can widely vary over time and among countries.

Which is the leading interest rate, in parallel to which all the others move?
Does it exist such an interest rate? Well, in some analysis it may be easier to
consider just one interest rate, but in reality there is no guarantee that all the
others will move exactly in parallel.

Still, the IS-LM model makes usually reference to one interest rate, influenced
by the central bank and having an impact on investment.

Determinants

Changes in interest rates structure depend on reasons that are both internal
and external to financial markets:

1. Different types of interest rate are linked and influence each others, so that
the functioning of the financial markets and their international relationships
explain a good deal of interest rate fluctuations.

2. Economic performance, perspective and expectations of potential loan

receivers as well as in the overall economy play an important role.

To keep things easy, we could say that interest rates are determined in
negotiations, which are more or less public, binding a larger or narrower
number of contrahents, more or less depending on publicly available
benchmark rates.
In a sentence, interest rates are set within institutional agreements.

Central bank policy is one of the most powerful factor impacting on these
agreements, for example through the instrument of direct determination of
official discount rate or the rate for refinancing operations.

An increase of money offered in the interbank market by the central bank is

conducive to a fall in the interbank rate, upon which many contracts are
based.

To the extent the Ministry of Treasury influences the interest rates on its own
bonds, it provides an important reference point for the economy.

Since for many banks the risky commercial loans to firms are alternative to
safe Treasury bonds, there are paradoxically situations in which the interest
rate policy in the hands of the Treasury not less than of the central bank.

International tendencies exert an important influence on domestic conditions

as well, since financial markets are now global in scope and there is a growing
co-operation among central banks.

Still, domestic commercial bank policies say the last words on loan agreements
and conditions.

In general, an increase of interest rates may be provoked by the following

factors alternatively or cumulatively:
1. an anti-inflationary policy of the central bank, based on restrictions to the
growth of the nominal money supply and on rising discount interest rate;
2. a policy by the central bank aimed at revaluating the currency or defending
it from devaluation,
3. the attempt of the Treasure of covering public deficit by issuing more bonds
in an unwilling market,
4. an attempt of banks of widening their margins, possibly as a reaction to
losses,
5. any increase in other interest rates, also foreign rates arisen for whatsoever
reason.

By contrast, a fall in interest rates may be justified especially by the following

reasons:
1. an expansionary policy of the central bank,
2. the requests of industrialists and trade unions for cheaper money in front of
a crisis,
3. a loose monetary policy due to a commitment to a fast export-led growth;
4. the end of an inflationary phase;
5. the relaxation of the need for defending the exchange rate, for example
thanks to a new monetary union.
Impact on other variables

The traditional effects on an increase of interest rates are, among others, the
following:
1. a fall in stock exchange;
2. a fall in profitability of firms;
3. a fall in private investment;
4. a fall in consumption credit;
5. an inflow of capital for buying bonds;
6. an upward pressure on exchange rate.

Still, the general environment in which the rise takes place is crucial, since
such effects can be completely absorbed by other (more powerful) forces.

Similarly, a non-linear relationship could be worth considering between the

size of rate increase and the differentiated effects on real and financial markets.

In fact, a small change in the official discount rate might arguably have no real
effect at all, while triggering substantial echos on financial markets.

By contrast, a large and abrupt increase in general interest rates can have
devasting effects on crucial real variables, exerting a depressing pressure on
GDP and the economy at large.

Long-term trends

Interest rates fluctuate over time with an historical ceiling, i.e. a maximum
level. Even though in high-inflation periods the nominal interest rate can reach
extremely high levels, for long decades a ceiling of 10% is a rule for many
countries.

Nominal interest rates have a minimum floor of zero.

Business cycle behavior

Interest rates primarily depend on policy and expectations, thus the

relationships with the business cycle depend on explicit decisions and
subjective judgments of key players.

If the interest rates are mainly used to fine tune the business cycle, then they
will fall in recessions, slightly but steadily rise with recovery and, finally, will be
increased at the end of the growth period to brake possible inflationary
dynamics. Soft landing will be targeted, even though hard landing with a
recession is an equally likely outcome. In this case, interest rates are pro-
cyclical, with usually short-run interest rate being more markedly pro-cyclical
than long-term rates.

But other policy rules would imply different behaviour. For instance, if the
target is mainly inflation, during a stagflation period (a depressed GDP with
high inflation) the interest rates may be particularly high, thus a counter-
cyclical pattern would emerge.

Interest Rates and Exchange Rates:

Interest rates also cause an appreciation in the exchange rate. Higher interest
rates make it more attractive to save money in the UK. Therefore, this causes
hot money flows into the UK and an appreciation in the exchange rate. Rising
interest rates have a negative impact on companies that carry a large current
debt load or that need to take on more debt because when interest rates rise,
the cost of borrowing money rises, too. Ultimately, the company’s profitability
and ability to grow are reduced. When a company’s profits (or earnings) drop,
its stock becomes less desirable, and its stock price falls.

Evaluation of Interest rate increases

1. Depends on situation of Economy.

If the economy is at full capacity a rise in interest rates may reduce inflation,
but not growth. However, if there is already spare capacity then rising interest
rates could cause a recession.

2. Depends on Other Components of AD.

For example, if exports are rising, or if consumers confidence is high; rising

interest rates may not reduce AD. For example, in the UK interest rates have
risen 2% since 2003, however, consumer spending is still strong.

3. Income effect of higher interest rates.

Higher return on saving may give some consumers a high income. This will be
consumers like pensioners. However, in the UK, the savings ratio is quite high,
therefore the income effect of a rise in interest rates is likely to be quite low.
The substitution effect will be high
Importance of interest rates

Interest rates are important factor on an economy as they control the flow of
money in the economy. High interest rates curb inflation, but also slow down
the economy. Low interest rates stimulate the economy, but could lead to
inflation. Therefore, you need to know not only whether rates are increasing or
decreasing, but what other economic indicators are saying.

 If interest rates are increasing and the Consumer Price Index (CPI) is
decreasing, this means the economy is not overheating, which is good.
 But, if rates are increasing and GDP is decreasing, the economy is
slowing too much, which is bad.
 If rates are decreasing and GDP is increasing, the economy is speeding
up, and that is good.
 But, if rates are decreasing and the CPI is increasing, the economy is
headed towards inflation.

Increase in interest rate analyzed

Despite a substantial body of empirical analysis, the answer based on the past
two decades of research is mixed. While many studies suggest, at most, a
single-digit rise in the interest rate when government debt increases by one
percent of GDP, others estimate either much larger effects or find no effect.
Comparing results across studies is complicated by differences in economic
models, definitions of econometric approaches, and sources of data. Using a
standard set of data and a simple analytical framework, it was reconsidered
and added to empirical evidence on the effect of federal government debt and
interest rates. It begins by deriving analytically the effect of government debt on
the real interest rate and find that an increase in government debt equivalent
to one percent of GDP would be predicted to increase the real interest rate by
about two to three basis points. While some existing studies estimate effects in
this range, others find larger effects. In almost all cases, these larger estimates
come from specifications relating federal deficits (as opposed to debt) and the
level of interest rates or from specifications not controlling adequately for
macroeconomic influences on interest rates that might be correlated with
deficits.

An Empirical Analysis:

An empirical analysis was presented in two parts. First, a variety of

conventional reduced-form specifications linking interest rates and government
debt and other variables was examined. In particular, it provided estimates for
three types of specifications to permit comparisons among different approaches
taken in previous research; it was estimated that the effect of: an expected, or
projected, measure of federal government debt on a forward-looking measure of
the real interest rate; an expected, or projected, measure of federal government
debt on a current measure of the real interest rate; and a current measure of
federal government debt on a current measure of the real interest rate. Most of
the statistically significant estimated effects are consistent with the prediction
of the simple analytical calculation.

Second, evidence was provided using vector auto regression analysis. In

general, these results are similar to those found in the reduced-form
econometric analysis and consistent with the analytical calculations. Taken
together, the bulk of these empirical results suggest that an increase in federal
government debt equivalent to one percent of GDP, all else equal, would be
expected to increase the long-term real rate of interest by about three basis
points, though one specification suggests a larger impact, while some estimates
are not statistically significantly different from zero.
Why does government increase interest rate?

Fluctuation in interest rates in an economy indicates an active economy as

they control the flow of money in the economy. However there are several
reasons behind the decision of a government to increase the interest rates, but
the main cause of high interest rates is high inflation, through the expected
inflation premium. High interest rates tends to curb the inflationary trend in
an economy, therefore interest rates have to be relatively high to achieve a
desired disinflation in order to cope up with increasing inflation in an economy
and this is done by tightening the monetary policy and making and implying
an anti-inflation policy which means “short-term pain for long-term gain.”

Interest Rate and Monetary Policy:

Monetary policy is the process by which the government, central bank, or
monetary authority manages the supply of money, or trading in foreign
exchange markets. Monetary theory provides insight into how to craft optimal
monetary policy.

Monetary policy is generally referred to as either being an expansionary policy,

or a contractionary policy, where an expansionary policy increases the total
supply of money in the economy, and a contractionary policy decreases the
total money supply. Expansionary policy is traditionally used to combat
unemployment in a recession by lowering interest rates, while contractionary
policy has the goal of raising interest rates to combat inflation (or cool an
otherwise overheated economy). Monetary policy should be contrasted with
fiscal policy, which refers to government borrowing, spending and taxation.

Monetary policy rests on the relationship between the rates of interest in an

economy, that is the price at which money can be borrowed, and the total
supply of money. Monetary policy uses a variety of tools to control one or both
of these, to influence outcomes like economic growth, inflation, exchange rates
with other currencies and unemployment.

Types of monetary policies depending on interest rates :

In practice all types of monetary policy involve modifying the amount of base
currency (M0) in circulation. This process of changing the liquidity of base
currency through the open sales and purchases of (government-issued) debt
and credit instruments is called open market operations.

Constant market transactions by the monetary authority modify the supply of

currency and this impacts other market variables such as short term interest
rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with
the set of instruments and target variables that are used by the monetary
authority to achieve their goals.

Target Market
Monetary Policy: Long Term Objective:
Variable:

Interest rate on
Inflation Targeting A given rate of change in the CPI
overnight debt

Price Level Interest rate on

A specific CPI number
Targeting overnight debt

Monetary The growth in money

A given rate of change in the CPI
Aggregates supply

Fixed Exchange The spot price of the

The spot price of the currency
Rate currency

Low inflation as measured by the

Gold Standard The spot price of gold
gold price
 Usually unemployment + CPI
Mixed Policy Usually interest rates
change

The contraction of the monetary supply can be achieved indirectly by

increasing the nominal interest rates. Monetary authorities in different nations
have differing levels of control of economy-wide interest rates. In the United
States, the Federal Reserve can set the discount rate, as well as achieve the
desired Federal funds rate by open market operations. This rate has significant
effect on other market interest rates, but there is no perfect relationship. In the
United States open market operations are a relatively small part of the total
volume in the bond market.

In other nations, the monetary authority may be able to mandate specific

interest rates on loans, savings accounts or other financial assets. By raising
the interest rate(s) under its control, a monetary authority can contract the
money supply, because higher interest rates encourage savings and discourage
borrowing. Both of these effects reduce the size of the money supply.
Effects of increased interest rates on an economy
An increase in the base rate will lead to an increase in the general cost of
borrowing, throughout the economy. Also higher interest rates increase the
return on saving money in an interest bearing account.

Therefore consumers will be less willing to borrow, e.g. on credit cards and
personal loans. Also, consumers with variable mortgages will have an increase
in monthly payments, therefore, they will have a reduction in disposable
income. This will cause a significant fall in consumer spending. Similarly, the
increase in borrowing costs will also reduce business investment.

Therefore with a fall in consumption and investment there is likely to be a fall

in Aggregate Demand, or more accurately, Aggregate Demand will increase at a
slower rate.

Therefore higher interest rates tend to reduce the rate of economic growth and
inflation.

However, the effect of a rise in interest rates depends on various factors. Rising
interest rates have various economic effects, some of them includes:

1. Effect on Savings (income and substitution effect) :

Higher interest rates encourage savings and therefore reduce

consumption (substitution effect). However, higher interest rates also
increase income, for those with high levels of savings (income effect).
Therefore, some consumers may actually increase spending. For
example, in Japan many firms are currently investing out of savings.
Therefore, an increase in interest rates is unlikely to discourage
investment. In the Pakistan, levels of debt are high and the savings ratio
low, therefore, rising interest rates will be more likely to reduce
investment and consumer spending in our country.

2. Increases the cost of borrowing :

 Interest payments on credit cards and loans are more expensive.
Therefore this discourages people from borrowing and saving. People who
already have loans will have less disposable income because they spend
more on interest payments. Therefore other areas of consumption will
fall.

3. Increase in mortgage interest payments :

Related to the first point is the fact that interest payments on variable
mortgages will increase. This will have a big impact on consumer
spending. This is because a 0. 5% increase in interest rates can increase
the cost of a £100,000 mortgage by £60 per month. This is a significant
impact on personal disposable income.

4. Increased incentive to save rather than spend.

5. Rising interest rates affect both consumers and firms :

Therefore the economy is likely to experience falls in consumption and

investment.

6. Government debt interest payments increase :

Higher interest rates increase the cost of government interest payments.

This could lead to higher taxes in the future.

7. The State of the Economy :

If the economy is growing above the trend rate of economic growth and is
close to full capacity, a rise in interest rates will have the effect of
moderating growth and reduce inflation. However, it is unlikely to cause
a recession because the rest of the economy is buoyant.

8. Effects people in different ways :

The effect of rising interest rates does not affect each consumer equally.
Those consumers with large mortgages (often first time buyers in the 20s
and 30s) will be disproportionately affected by rising interest rates. As a
consequence to reduce inflation may require interest rates to rise to a
level that cause real hardship to those with large mortgages. This makes
monetary policy less effective as a macroeconomic tool.
 9. Reduces consumer Confidence :

Interest rates have an effect on consumer and business confidence. A

rise in interest rates discourages investment it makes firms and
consumers less willing to take out risky investments and purchases. If
consumer confidence is high then rising interest rates may not
discourage spending; people may just be willing to pay more interest.
However, at other times a rise in interest rates may adversely affect
confidence; therefore, the effect will be much greater.

10. Effect on Real Interest Rate :

It is worth bearing in mind that what is important is the real interest

rate. The real interest rate is nominal interest rates minus inflation. For
example: If interest rates rose from 5% to 6% but inflation rose from 2%
to 5.5 %. This actually represents a cut in real interest rates from 3% (5-
2) to 0.5% (6-5.5) Thus in this circumstance the rise in nominal interest
rates actually represents expansionary monetary policy.

11. Effects on Exchange Rate :

Higher interest rates cause hot money flows, because it is more attractive
to save money. Therefore, this will cause an appreciation in the exchange
rate. An appreciation will make exports more expensive and imports
cheaper. Assuming demand for exports and imports is relatively elastic,
then an appreciation will reduce the growth of aggregate demand and
help reduce inflation.

12. Time Lag :

It is estimated interest rate changes can take up to 18 months to have its

full effect. Therefore, an increase in interest rates now, may reduce
growth in the future. For example if you have an investment project 50%
completed you are likely to finish it off. However the higher interest rates
may discourage starting a new project in the next year.

Some other effects of higher interest rates are that the refinance market slows
down. Homeowners who want to refinance their current mortgage into another
one with a lower rate will table their refinance plans when rates rise. They'll be
back in the market when interest rates drop again.

Home buyers are more adversely affected by rising rates. Higher interest rates
make it harder for buyers to qualify for financing. When rates rise too high,
buyers have to scale back their expectations and buy more affordable, less
expensive properties. Marginally qualified buyers are most profoundly affected
by rate increases. If you barely qualify for a $200,000 mortgage at 6.75
percent, you probably won't qualify for the same size mortgage with interest
rates 1/2 to 3/4 percent higher.

One alternative way to keep housing affordable when interest rates rise is to
switch from fixed to adjustable-rate financing. During the first week in June
this year, the average initial interest on a one-year adjustable-rate mortgage
(one where the interest rate is adjusted annually) was 5.85 percent.

Some buyers are nervous about taking an adjustable-rate mortgage (ARM)

when rates are rising. Even though most ARMs limit how high the interest rate
can go during the life of the loan, home buyers often feel more comfortable with
stable monthly housing payments. For such buyers, a hybrid mortgage, also
called a fixed-period ARM, is another way to keep financing more affordable
when rates rise.

A hybrid mortgage is one that has a fixed interest rate for a period of time,
usually for 3, 5, 7 or 10 years. After the fixed interest rate period, the interest
fluctuates for the remaining term of the loan. The initial fixed interest rate on a
10-year fixed ARM is approximately 1/2 percent lower than it is on a 30-year
fixed-rate loan. With a 10-year fixed ARM, it's likely that the homeowner will
never experience rate fluctuations because statistics show that most
homeowners either sell their home and pay off the mortgage or refinance within
5 to 7 years.

It is commonly believed that when money and credit tightens and interest rates
rise, certain groups of borrowers are more seriously affected than others. Small
businesses, public utilities, State and local governments and consumers are all
types of borrowers that are typically believed to be seriously affected. Also, all
participants in the mortgage market and construction industry, including
borrowers and lenders of nortgage credit, construction companies and workers,
are frequently hit hard by scarce and expensive credit.

There are several channels through which these groups may be forced to bear a
disproportionate share of the adverse effects of high interest rates and tight
credit.

Affecting a company’s customers:

A company’s success comes when it sells its products or services. But what
happens if increased interest rates negatively impact its customers (specifically,
other companies that buy from it)? The financial health of its customers
directly affects the company’s ability to grow sales and earnings. For a good
example of this situation, consider what happened to Cisco Systems in 2000.
Because a huge part of its sales went to the telecommunications industry,
Cisco’s profitability depended on the health of that entire industry. The telecom
industry’s debt ballooned to $700 billion. This debt became the telecom
industry’s financial Achilles heel, which, in turn, became a pain in the neck to
Cisco. Because telecom companies bought less (especially from Cisco), Cisco’s
profits shrank. From March 2000 to March 2001, Cisco’s stock fell by nearly
70 percent! As of September 2001, Cisco’s stock price continued to decline
because the companies that were Cisco’s customers were hurting financially.

Impacting investors’ decision-making considerations:

When interest rates rise, investors start to rethink their investment strategies,
resulting in one of two outcomes: Investors may sell any shares in interest-
sensitive stocks that they hold. Interest-sensitive industries include electric
utilities, real estate, and the financial sector. Although increased interest rates
can hurt these sectors, the reverse is also generally true: Falling interest rates
boost the same industries. Keep in mind that interest rate changes affect some
industries more than others.

Investors who favor increased current income (versus waiting for the
investment to grow in value to sell for a gain later on) are definitely attracted to
investment vehicles that offer a higher rate of return. Higher interest rates can
cause investors to switch from stocks to bonds or bank certificates of deposit.

Hurting stock prices indirectly:

High or rising interest rates can have a negative impact on any investor’s total
financial picture. What happens when an investor struggles with burdensome
debt, such as a second mortgage, credit card debt, or margin debt (debt from
borrowing against stock in a brokerage account)? He may sell some stock in
order to pay off some of his high-interest debt. Selling stock to service debt is a
common practice that, when taken collectively, can hurt stock prices. The
stock market and the U.S. economy face perhaps the greatest challenge since
the Great Depression — debt. In terms of Gross Domestic Product (GDP), the
size of the economy is about $11.5 trillion (give or take $100 billion), but the
debt level is about $37 trillion. This already enormous amount does not include
$44 trillion of liabilities such as Social Security and Medicare. Additionally
(Yikes! There’s more?!), some of our financial institutions hold over $50 trillion
worth of derivatives. These can be very complicated and sophisticated
investment vehicles that can backfire. Derivatives have, in fact, sunk some
large organizations (such as Enron), and investors should be aware of them.
Just check out the company’s financial reports.

Because of the effects of interest rates on stock portfolios, both direct and
indirect, successful investors regularly monitor interest rates in both the
general economy and in their personal situations. Although stocks have proven
to be a superior long-term investment (the longer the term, the better), every
investor should maintain a balanced portfolio that includes other investment
vehicles, such as money market funds, savings bonds, and/or bank
investments.

A diversified investor has some money in vehicles that do well when interest
rates rise. These vehicles include money market funds, U.S. savings bonds
(EE), and other variable-rate investments whose interest rates rise when
market rates rise. These types of investments add a measure of safety from
interest rate risk to your stock portfolio.

Government increases interest rate:

Fluctuation in interest rates in an economy indicates an active economy as

they control the flow of money in the economy. However there are several
reasons behind the decision of a government to increase the interest rates, but
the main cause of high interest rates is high inflation, through the expected
inflation premium. High interest rates tends to curb the inflationary trend in
an economy, therefore interest rates have to be relatively high to achieve a
desired disinflation in order to cope up with increasing inflation in an economy
and this is done by tightening the monetary policy and making and implying
an anti-inflation policy which means “short-term pain for long-term gain.”
 Interview Of Dr Shamshad Akhtar (Governor State Bank)

Background:
Monetary policy management and financial sector stability are two primary
roles of State Bank of Pakistan (SBP). Monetary policy and process of its
formulation in Pakistan has undergone changes with the evolving economic
dynamics within the country and the improved empirical and theoretical
understanding of the monetary policy across the world. Monetary policy in
Pakistan, in line with SBP Act, has been supportive of the dual objective of
promoting economic growth and price stability. It achieves this goal by
targeting monetary aggregates (broad money supply growth as an intermediate
target and reserve money as an operational target) in accordance with real GDP
growth and inflation targets set by the Government. Over the years, while
maintaining the broad legal mandate, SBP has improved the quality of
monetary formulation and its process quite significantly.

This morning, I propose to first outline measures taken by the Government and
SBP to strengthen the monetary policy management. Second, I will discuss the
rationale and key elements of SBP current monetary policy stance which I
believe is helping bring down inflation without stifling credit or economic
growth. Finally, I will discuss the impact of SBP’s policy actions, and
challenges in its implementation.

Changes in monetary policy management:

SBP shifted its reliance from an administered monetary policy regime governed
by ad hoc changes in reserve ratio’s, directed credit and regulated interest rate
policies in mid 1990s to a liberal and market oriented monetary policy
management. Abolishing sector and bank credit limits, central bank adopted
“3-day SBP discount rate” as a major policy instrument to signal easing or
tightening of monetary policy which essentially responded to the demand
pressures of the economy in line with the growth trends in monetary liabilities
and monetary assets – with former capturing the growth in currency and
deposit base and latter the growth in domestic credit (including both
government borrowings and private sector credit). Generally monetary module
of the economy is the least understood area. This is largely because monetary
segment of the economy deals with on one hand the changes in stocks and
flows of money supply and on the other hand trends in it subsumes and
defuses the impact of developments of fiscal and balance of payments
accounts. Notwithstanding both sides of the balance sheet of monetary
accounts impact price behavior.

As highlighted above, broad money supply growth has to be consistent with the
targets of growth in real GDP and inflation rate. However, if there are excessive
demand pressures either because of high fiscal deficit or because of the
excessive foreign inflows money supply grows faster than the growth in
productive sectors and generates demand pressures which manifests itself in
rise in inflation rate. Despite all contests and debates, inflation is primarily a
monetary phenomenon. To keep it under control it is critical that
macroeconomic imbalances are kept within the permissible limits. Fiscal
profligacy in the past has resulted in Government’s unlimited recourse to low
and fixed interest rate financing.

While interest rates were kept low to nurture private sector credit growth -- this
did not traditionally happen as private sector investment remained subdued
due to host of structural problems facing the economy. Instead low interest
rates nurtured fiscal indiscipline as the Government continued to borrow at
cheaper rates to finance expenditures. Recognizing this dilemma, qualitatively
monetary policy formulation and its implementation underwent profound
changes. In 1997, SBP and its Central Board were empowered to formulate,
conduct and implement monetary policy and a Monetary and Fiscal
Coordination Board was established to ensure fiscal policy is well coordinated
with the monetary policy – specific provision of SBP Act mandates Central
Board to impose limits on Government’s central bank borrowing. In 2005, the
Fiscal Responsibility and Debt Limitation Act 2005 requires Government to
reduce its revenue deficit to zero by 30th June 2008 and maintain it thereafter,
and concurrently reduce public debt to sixty percent of GDP by 2013 and
below that limit thereafter. Compliance with the two pieces of legislation has
been underway and over the period will help in eventually curbing more
effectively Government’s recourse to central bank borrowing – which
traditionally has complicated monetary policy management. With greater
powers to formulate monetary policy, SBP moved to market oriented monetary
policy where it relied more on interest rate to serve as a policy fulcrum and
developed its capacity to manage financial markets and related activities
effectively. Proactive conduct of monetary operations and management of
market volatility has helped improve market flows.

The Open Market Operation (OMO) process has been institutionalized with
better flexibility vis-à-vis tenors and frequency. In 2005, SBP introduced the
Money Market Computerized Reporting System (MM-CRS) for banks which
helps in assessing the market liquidity. SBP’s treasury operations and gradual
improvements in its liquidity management have together helped OMOs and
money market development.

Current monetary policy stance:

Public, businesses and market needs to develop understanding that monetary
policy does indeed, over the long run, determine the behavior of the price level.
While inflation is precipitated by supply shocks, hoarding, official restrictions,
import prices, and so on, but these influence price level in a given year.
However, it is monetary policy that can prevent an effect on the rate of inflation
over a more extended period. That is, following the initial price level shock, an
appropriate adjustment of the interest rate (if necessary) can stop a potential
second round of repercussions on wages and prices.
Specialists use measures of core inflation, which exclude volatile prices, as a
way to see through one-off shocks. Core inflation is very useful to the central
bank itself, as a guide to the appropriate setting of its monetary policy stance.

Unexpectedly low (high) core inflation usually indicates the need for easing
(tightening) in the policy stance.
The ultimate objective of a central bank, and the measure of success of its
policy, is in terms of overall (i.e. headline) inflation. In this context, the way to
deal with price level shocks is to stress their temporary nature with respect to
the inflation rate. This involves: ensuring that the effect on inflation is only
temporary—this may or may not require a policy action, and realizing that as
monetary policy influences the trend of prices with a lag of at least a year and a
half, headline inflation should return to its pre-shock rate not within not 1 year
but 2 years. Price signals in a market economy operate less effectively when the
price level is unstable; in addition, resources are diverted to unproductive
speculation and hedging. Thus, countries with unstable price levels—high
inflation or deflation— almost always experience weak output and growth.
Thus, low inflation is not merely an end in itself, but also a means to good
overall economic performance. The main cause of high interest rates is high
inflation, through the expected inflation premium. Conversely, the best
prospect for low interest rates is a stable environment of low inflation. In this
context, the relatively high interest rates that may be necessary to achieve a
desired disinflation represent “short-term pain for long term gain.” SBP,
therefore, has a current focus on anti-inflation policy which will ensure steady
growth in the long run.

Since April 2005 in response to the headline inflation reaching 11.3%, SBP has
been and remains in monetary tightening phase. It has to be recognized that
the inflationary pressures build up in 2005 because of the preceding few years
of easy monetary policy. While SBP addressed this overhang by raising policy
discount rate from 7 to 9% in April 2005, there were renewed demand
pressures as fiscal and external account deficits rose in wake of both
international oil price increase as well as unforeseen spending demands
triggered by the earthquake. To offset additional demand pressures, SBP had to
further raise its policy discount rate by 50bp in July 2006 along with 4.5
percentage point upward revision in reserve ratios.
In line with the evidence observed for developing countries, impact of monetary
tightening on curbing inflation started to be visible after 12-18 months or so.
As aggregate demand pressures moderated, CPI fell to 7.9 percent in FY06
(remaining well within the annual target of 8%) and CPI continued to decline
to 7.7% in March 2007 with core inflation being still low at 5.4%. However, CPI
remains above annual target of 6.5% largely because of a number of factors
that disrupted the impact of monetary tightening:

(i) food prices remained quite volatile during FY07 due to supply disruptions;
(ii) higher fiscal pressures resulted in greater than planned recourse to the
central bank borrowing. More specifically, government has borrowed Rs. 180
billion for budgetary support by 14-April-2007 compared with only Rs. 37
billion during the same period last year. During the later part of FY the
Government has been retiring part of the central bank borrowing and financing
its deficit by external flows or commercial bank borrowings;
(iii) heavy borrowing from commercial banks seems to have been crowding out
private sector borrowing for long-term investment as banks find it convenient
to park their funds in government securities rather than lending;
(iv) SBP being mandated to provide higher than projected refinancing for the
textile sector – besides its high borrowing to meet working capital requirements
through EFS, textile exporters were allowed debt swap and new long term
borrowings which ranged around Rs50 billion; and
(v) higher than expected foreign inflows are expected to enhance the levels of
net foreign assets and result in monetary expansion. Together these factors
have resulted in 16.9% YoY growth in reserve money by 14 April (compared to
11.2% last year) which has translated into broad money supply growth of
17.3% by 14 April 07 – higher than the monetary policy statement’s original
projection of 13.5%. To avoid adverse impact of monetary tightening on
investment demand in the economy and the long-run growth momentum, SBP
has ensured proper liquidity management. Not only have the overnight rates
been kept close to the discount rate, but the volatility in the short-term interest
rates also reduced during H1-FY07. 6-months KIBOR rose by 58 bps to 10.2%
during July –April 07 and banks weighted average (marginal) lending rate has
increased from 9.9 % in June 2006 to 10.5 % in February 2007.

During July-April 14, net credit to private sector grew by Rs266.4 billion (or
12.6 %) against Rs 339.7 billion (or 19.8 %) in the corresponding period of
FY06. Despite liquidity in the system, commercial banks are not able to lend
because of low demand for private sector’s credit that has borrowed quite
heavily in last few years. While there has been growth in working capital, the
demand for fixed investment has been subdued. In some cases, corporate
sector is further meeting their demand either from retained earnings or foreign
borrowings. In some sectors, banks have deliberately slowed down to now
assess and develop their own capacities to lend more prudently. The process of
mergers and acquisition in a number of banks also impact private sector credit
as most “acquired banks” slowed down their business. Trends in key
macroeconomic variables indicate that SBP monetary policy stance has proved
successful in striking the required balance between curbing the demand side
inflationary pressures and supporting the growth momentum. Indications are
that the economy continues to grow at a robust pace on account of acceleration
in Large-scale Manufacturing (LSM) and agriculture, and the persistently
strong performance of services sector.

More importantly, core inflation, which had registered a sluggish decline in

FY06, has already witnessed a substantial deceleration during the first nine
months of FY07. By March 2007, YoY core inflation has come down to as low
as 5.4 percent, which is 1.25 percentage points lower than the 6.7 percent level
recorded during the corresponding period last year, 0.9 percentage points less
than the level observed in June 2006. This comforting decline in core inflation,
however, is eclipsed by the persistently high food inflation stemming principally
from supply side disturbances. In totality, the average consumer price index
(CPI) saw a rise of 8.0 percent during July-March FY07 relative to the annual
target of 6.5 percent for FY07. With inflation in Pakistan being relatively higher
compared to its competitors and trading partners, the Relative Price Index (RPI)
increased by 5.8 percent during first three quarters of FY07. Higher domestic
inflation has offset the gains emanating from nominal depreciation and the real
exchange rate, measured in terms of the real effective exchange rate (REER)
index, appreciated slightly by 2.5 percent during first three quarters of FY07.

Conclusion:
To conclude, so far, the current monetary policy posture appears to be striking
the balance of gradually reducing the excess demand pressures from the
economy, without prejudice to the high-growth prospects. In the short-term,
SBP will need to maintain its monetary tightening stance and enhance its
communication to influence inflation expectations, and effectively communicate
that concerns about the adverse effects of higher interest rates on
competitiveness and/or growth are ill founded as the real interest rates in
Pakistan are low relative to its competitors.

Answers of the Questions:

1. How has increase in interest rates helped the production sector?

With increase in interest rates the production sector has to suffer as because
the cost of borrowing will go up and the producers will have to pay higher
interest on the loans they have rendered.

Example: If a textile producer was taking a loan at 10% and now when the
interest has increased to 13% the cost of production has overall increased by 3
%, thus he will have to increase the price of his product in order to maintain
the same profit percentage. Now when he will increase the price the demand
will fall and his sales will be affected thus it has been proven that increase in
interest rate does not help the production sector.

2. How does increase in interest bring economic prosperity?

Interest rates directly affect the credit market (loans) because higher interest
rates make borrowing more costly. By changing interest rates, the Federal
Reserve tries to achieve maximum employment, stable prices and a good level
growth. As interest rates drop, consumer spending increases and this in turn
stimulates economic growth.

Contrary to popular belief, excessive economic growth can in fact be very

detrimental. At one extreme, an economy that is growing too fast can
experience hyperinflation, resulting in the problems we mentioned earlier. At
the other extreme, an economy with no inflation has essentially stagnated. The
right level of economic growth, and thus inflation, is somewhere in the middle.
It's the Fed's job to maintain that delicate balance. A tightening, or rate
increase, attempts to head off future inflation. An easing, or rate decrease,
aims to spur on economic growth. Hence an increaese in discount rate tends to
slow down economic growth but leading towars economic prosperity

3. How does increase in interest rate effect the economic prosperity

With the increase in interest rates the amount of saving will increase thus
people will save more spend less the demand pull inflation will be controlled as
because people will save more and the aggregate demand will go down
commercial bank will have more deposits thus more loans will be disbursed
and there will be an increase in the investments thus there will be more
employment people will have higher disposable income and a better standard of
living.

4. What is the effect of inflationary trends on discount rates?

Interest rates are decided by the Federal Reserve in an economy and

Inflation plays a vital role in the Federal Reserve’s decisions regarding
interest rates. When inflation is high discount rates also tend to increase as
they control the flow of money in the economy and curb inflation. Whereas
when inflation is low discount rates are also relatively low, this stimulates
the economy as well as adding up to inflationary trend of an economy.
5. What is the effect of increase in interest rates in CPI SPI and WPI

The chart shows how the effects of sustained inflation and increased discount
rates accumulate over the years. It contains the CPI index values for December
of each year. An index value of 180 means that prices have increased 80%
measured from a base of 100. From the index values, it is possible to calculate
that a basket of goods and services that cost $3,000 at the end of 1992 will
cost $3,897.00 at the end of 2003. Thus showing that discout rates and
Consumer Price Index are directly related to each other, an increase in
discount rate tends to increase the consumer price index CPI also.
6. Suppose the real interest rates in the rest of the world remain unchanged:
explain the effect of the real interest rates change in Pakistan on the
demand for Pakistani rupee in the foreign exchange market. What will
happen to exchange rate of Pakistani Rupee?

7. How does increase in interest rates effects the Stock Market

8. What is the effect of increase in interest rate in perfect competition?

If businesses operate under perfect competition, with only two factors of

production - labour (the variable factor) and capital (fixed in the short run) -
what happens when the interest rate (treated as cost of capital) rises and the
minimum efficient scale falls, in the short run and long run

Increased costs = higher prices and less output, possibly leading to negative
profits for some companies, in the long run, some companies will exit the
market, restoring the average economic profit to zero.

9. Explain how increased interest rate affects the taxes?

Depends on whom you plan to put more taxes, if on producers - then interest
rates will fall due to fall in demand for investments (money supply will remain
the same). But if on demand side - reducing disposable income effect will be
different - increase in interest rates due to reduction in money supply (as
function of disposable income).
10. Explain how the interest rate effect the can increase aggregate demand?

Changes in real interest rates affect the public's demand for goods and services
mainly by altering borrowing costs, the availability of bank loans, the wealth of
households, and foreign exchange rates.
For example, a decrease in real interest rates lowers the cost of borrowing; that
leads businesses to increase investment spending, and it leads households to
buy durable goods, such as autos and new homes.
In addition, lower real rates and a healthy economy may increase banks'
willingness to lend to businesses and households.