An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow

from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year[1]. Interest rates targets are also a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment.

Historical interest rates

Germany experienced deposit interest rates from 14% in 1969 down to almost 2% in 2003 In the past two centuries, interest rates have been variously set either by national governments or central banks. For example, the Federal Reserve federal funds rate in the United States has varied between about 0.25% to 19% from 1954 to 2008, while the Bank of England base rate varied between 0.5% and 15% from 1989 to 2009,[2][3] and Germany experienced rates close to 90% in the 1920s down to about 2% in the 2000s.[4][5] During an attempt to tackle spiraling hyperinflation in 2007, the Central Bank of Zimbabwe increased interest rates for borrowing to 800%.[6] This section requires expansion. The interest rates on prime credits in the late 1970s and early 1980s were far higher than had been recorded higher than previous US peaks since 1800, than British peaks since 1700, or than Dutch peaks since 1600; "since modern capital markets came into existence, there have never been such high long-term rates" as in this period.[7] Possibly before modern capital markets, there have been some accounts that savings deposits could achieve an annual return of at least 25% and up to as high as 50%. (William Ellis and Richard Dawes, "Lessons on the Phenomenon of Industrial Life... ", 1857, p III-IV)

Interest Rates in the United States

In the United States, authority for interest rate decisions is divided between the Board of Governors of the Federal Reserve (Board) and the Federal Open Market Committee (FOMC). The Board decides on changes in discount rates after recommendations submitted by one or more of the regional Federal Reserve Banks. The FOMC decides on open market operations, including the desired levels of central bank money or the desired federal funds market rate.

[edit] Reasons for interest rate change

Political short-term gain: Lowering interest rates can give the economy a short-run boost. Under normal conditions, most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. The quick boost can influence elections. Most economists advocate independent central banks to limit the influence of politics on interest rates. Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. Since according to time preference theory people prefer goods now to goods later, in a free market there will be a positive interest rate. Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. Alternative investments: The lender has a choice between using his money in different investments. If he chooses one, he forgoes the returns from all the others. Different investments effectively compete for funds. Risks of investment: There is always a risk that the borrower will go bankrupt, abscond, die, or otherwise default on the loan. This means that a lender generally charges a risk premium to ensure that, across his investments, he is compensated for those that fail. Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on a higher rate to make up for this loss.

Real vs nominal interest rates

Further information: Fisher equation The nominal interest rate is the amount, in money terms, of interest payable. For example, suppose a household deposits $100 with a bank for 1 year and they receive interest of $10. At the end of the year their balance is $110. In this case, the nominal interest rate is 10% per annum. The real interest rate, which measures the purchasing power of interest receipts, is calculated by adjusting the nominal rate charged to take inflation into account. (See real vs. nominal in economics.) If inflation in the economy has been 10% in the year, then the $110 in the account at the end of the year buys the same amount as the $100 did a year ago. The real interest rate, in this case, is zero. After the fact, the 'realized' real interest rate, which has actually occurred, is given by the Fisher equation, and is

where p = the actual inflation rate over the year. The linear approximation is widely used. The expected real returns on an investment, before it is made, are: where: = real interest rate = nominal interest rate = expected or projected inflation over the year

Market interest rates

There is a market for investments which ultimately includes the money market, bond market, stock market and currency market as well as retail financial institutions like banks. Exactly how these markets function is a complex question. However, economists generally agree that the interest rates yielded by any investment take into account:

The risk-free cost of capital Inflationary expectations The level of risk in the investment The costs of the transaction

This rate incorporates the deferred consumption and alternative investments elements of interest.
[edit] Inflationary expectations

According to the theory of rational expectations, people form an expectation of what will happen to inflation in the future. They then ensure that they offer or ask a nominal interest rate that means they have the appropriate real interest rate on their investment. This is given by the formula:

where:
= offered nominal interest rate = desired real interest rate = inflationary expectations

Risk

The level of risk in investments is taken into consideration. This is why very volatile investments like shares and junk bonds have higher returns than safer ones like government bonds. The extra interest charged on a risky investment is the risk premium. The required risk premium is dependent on the risk preferences of the lender. If an investment is 50% likely to go bankrupt, a risk-neutral lender will require their returns to double. So for an investment normally returning $100 they would require $200 back. A riskaverse lender would require more than $200 back and a risk-loving lender less than $200. Evidence suggests that most lenders are in fact risk-averse. Generally speaking a longer-term investment carries a maturity risk premium, because longterm loans are exposed to more risk of default during their duration.
[edit] Liquidity preference

Most investors prefer their money to be in cash than in less fungible investments. Cash is on hand to be spent immediately if the need arises, but some investments require time or effort to transfer into spendable form. This is known as liquidity preference. A 1-year loan, for instance, is very liquid compared to a 10-year loan. A 10-year US Treasury bond, however, is liquid because it can easily be sold on the market.
A market interest-rate model

A basic interest rate pricing model for an asset

Assuming perfect information, pe is the same for all participants in the market, and this is identical to:

where
in is the nominal interest rate on a given investment ir is the risk-free return to capital i*n = the nominal interest rate on a short-term risk-free liquid bond (such as U.S. Treasury Bills). rp = a risk premium reflecting the length of the investment and the likelihood the borrower will default lp = liquidity premium (reflecting the perceived difficulty of converting the asset into money and thus into goods).

[edit] Interest rate notations

What is commonly referred to as the interest rate in the media is generally the rate offered on overnight deposits by the Central Bank or other authority, annualized. The total interest on an investment depends on the timescale the interest is calculated on, because interest paid may be compounded. In finance, the effective interest rate is often derived from the yield, a composite measure which takes into account all payments of interest and capital from the investment. In retail finance, the annual percentage rate and effective annual rate concepts have been introduced to help consumers easily compare different products with different payment structures.

Interest rates in macroeconomics

[edit] Elasticity of substitution

The elasticity of substitution (full name should be the marginal rate of substitution of the relative allocation) affects the real interest rate. The larger the magnitude of the elasticity of substitution, the more the exchange, and the lower the real interest rate.
[edit] Output and unemployment

Interest rates are the main determinant of investment on a macroeconomic scale. The current thought is that if interest rates increase across the board, then investment decreases, causing a fall in national income. However, the Austrian School of Economics sees higher rates as leading to greater investment in order to earn the interest to pay the depositors. Higher rates encourage more saving and thus more investment and thus more jobs to increase production to increase profits. Higher rates also discourage economically unproductive lending such as consumer credit and mortgage lending. Also consumer credit tends to be used by consumers to buy imported products whereas business loans tend to be domestic and lead to more domestic job creation [and/or capital investment in machinery] in order to increase production to earn more profit. A government institution, usually a central bank, can lend money to financial institutions to influence their interest rates as the main tool of monetary policy. Usually central bank interest rates are lower than commercial interest rates since banks borrow money from the central bank then lend the money at a higher rate to generate most of their profit. By altering interest rates, the government institution is able to affect the interest rates faced by everyone who wants to borrow money for economic investment. Investment can change rapidly in response to changes in interest rates and the total output

Open Market Operations in the United States

The effective federal funds rate in the US charted over more than half a century[citation needed]

The Federal Reserve (often referred to as 'The Fed') implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed. Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates. Using the power to buy and sell treasury securities.
[edit] Money and inflation

Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply. By setting i*n, the government institution can affect the markets to alter the total of loans, bonds and shares issued. Generally speaking, a higher real interest rate reduces the broad money supply. Through the quantity theory of money, increases in the money supply lead to inflation.

Negative interest rates

Nominal interest rates are normally positive, but not always. Given the alternative of holding cash, and thus earning 0%, rather than lending it out, profit-seeking lenders will not lend below 0%, as that will guarantee a loss, and a bank offering a negative deposit rate will find few takers, as savers will instead hold cash.[8] However, central bank rates can, in fact, be negative; in July 2009 Sweden's Riksbank was the first central bank to use negative interest rates, lowering its deposit rate to 0.25%, a policy advocated by deputy governor Lars E. O. Svensson.[9] This negative interest rate is possible

because Swedish banks, as regulated companies, must hold these reserves with the central bankthey do not have the option of holding cash[citation needed]. More often, real interest rates can be negative, when nominal interest rates are below inflation. When this is done via government policy (for example, via reserve requirements), this is deemed financial repression, and was practiced by countries such as the United States and United Kingdom following World War II (from 1945) until the late 1970s or early 1980s (during and following the PostWorld War II economic expansion).[10][11] In the late 1970s, United States Treasury securities with negative real interest rates were deemed certificates of confiscation.[12] Negative interest rates have been proposed in the past, notably in the late 19th century by Silvio Gesell.[13] A negative interest rate can be described (as by Gesell) as a "tax on holding money"; he proposed it as the Freigeld (free money) component of his Freiwirtschaft (free economy) system. To prevent people from holding cash (and thus earning 0%), Gesell suggested issuing money for a limited duration, after which it must be exchanged for new billsattempts to hold money thus result in it expiring and becoming worthless. Along similar lines, John Maynard Keynes approving cited the idea of a carrying tax on money,[13] (1936, The General Theory of Employment, Interest and Money) but dismissed it due to administrative difficulties.[14] More recently, a carry tax on currency was proposed by a Federal Reserve employee (Marvin Goodfriend) in 1999, to be implemented via magnetic strips on bills, deducting the carry tax upon deposit, with the tax based on how the bill had been held.[14] It has been proposed that a negative interest rate can in principle be levied on existing paper currency via a serial number lottery: choosing a random number 0 to 9 and declaring that bills whose serial number end in that digit are worthless would yield a negative 10% interest rate, for instance (choosing the last two digits would allow a negative 1% interest rate, and so forth). This was proposed by an anonymous student of N. Gregory Mankiw,[13] though more as a thought experiment than a genuine proposal.[15]

Factors Influencing Interest Rates

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An interest rate is the amount received in relation to an amount loaned, generally expressed as a ratio of dollars received per hundred dollars lent. However, a distinction should be made between specific interest rates and interest rates in general. Specific interest rates on a particular financial instrument (for example, a mortgage or bank certificate of deposit) reflect the time for which the money is on loan, the risk that the money may not be repaid, and the current supply and demand in the marketplace for funds available for lending. Some specific rates, such as those on Treasury or corporate bonds, are set in dealer markets by negotiations between buyers and sellers, and are called market rates. These rates are subject to change daily. Other rates, such as the bank prime rate (which is the interest rate that banks charge their best customers) or the Federal Reserve discount rate (the rate at which banks can borrow funds from the Federal Reserve) are set by some established group, and are known as administered rates. But these administered rates would not exist for very long if they didnt reflect some prevailing underlying forces. Ultimately they reflect market rates. There are a number of forces that must be taken into account when attempting to evaluate the current and future movement of interest rates. To begin with, interest rates are strongly influenced by the condition of the U.S. economy. When the economy is growing, consumers have jobs and savings to lend through banks, but they must also borrow for large items, such as homes or cars, or to finance other purchases through credit cards. As the demand for funds increases, interest rates rise and act as a ration for the funds available. Of course, the opposite is also true; when the demand for funds is low, interest rates fall. Inflationary pressures will also affect interest rates, because the rates paid on most loans are fixed in the loan contract. A lender may be reluctant to lend money for any period of time if the purchasing power of that money will be less when its repaid; the lender will, therefore, demand a higher rate (known as an inflationary premium). Thus, inflation pushes interest rates higher; deflation causes rates to decline. The actions of the federal government have an effect on interest rates as well, because it is the nations largest borrower. The federal government has first claim on available funds in the marketplace. Because of its vast taxing powers and the strength of the U.S. economy, the federal government has the highest credit rating and its debt is therefore a preferred investment. International forces play an important role in influencing interest rates in the United States. To the extent that foreign investors are willing to lend money to the U.S., they supplement domestic sources of funds in the marketplace, driving interest rates down. If they were to decide to reduce or sell their holdings in the U.S. and reinvest elsewhere, more needed funds would have to come from domestic sources, which would push rates upward. The dollar is the main currency in international trade and is used extensively in world markets. Orderly fluctuations of the dollar in foreign exchange markets are essential for domestic and international stability. Major or very volatile exchange rate movements could force the Federal Reserve to act, as well as affect interest rates and U.S. monetary policy. Changes in the condition of the U.S. financial system will also have a significant effect on interest rates. If any large financial institution is threatened with collapse, it would not default on the funds which are owed to its depositors, as was the case in the 1930s. The federal government would take action to make good the deposits, regardless of the impact on the federal budget deficit. The Federal

Reserve would open bank reserves as necessary, increasing the supply of funds in the market, and sending interest rates down, at least initially. Its likely that the most important force to watch for evaluating future interest rate trends is the Federal Reserve. The Fed, as it is known, controls credit availability (in other words, the amount of funds available to lend) and the level of interest rates at which the funds are made available. Its importance in the operation of the financial system is beyond the scope of this article alone. Please read the article series The Federal Reserve for a more detailed discussion of this topic.

When interest rates change, it is the result of many complex factors. People who study interest rates find that it is as difficult to forecast future interest rates as it is the weather. Since interest rates reflect human activity, a long-term forecast is virtually impossible. After the fact, explanations are many and confident! Some of the major factors which help to dictate interest rates are explained below.

Supply and Demand for Funds Interest rates are the price for borrowing money. Interest rates move up and down, reflecting many factors. The most important among these is the supply of funds, available for loans from lenders, and the demand, from borrowers. For example, take the mortgage market. In a period when many people are borrowing money to buy houses, banks and trust companies need to have the funds available to lend. They can get these from their own depositers. The banks pay 6% interest on five year GICs and charge 8% interest on a five year mortgage. If the demand for borrowing is higher than the funds they have available, they can raise their rates or borrow money from other people by issuing bonds to institutions in the "wholesale market". The trouble is, this source of funds is more expensive. Therefore interest rates go up! If the banks and trust companies have lots of money to lend and the housing market is slow, any borrower financing a house will get "special rate discounts" and the lenders will be very competitive, keeping rates low. This happens in the fixed income markets as a whole. In a booming economy, many firms need to borrow funds to expand their plants, finance inventories, and even acquire other firms. Consumers might be buying cars and houses. These keep the "demand for capital" at a high level, and interest rates higher than they otherwise might be. Governments also borrow if they spend more money than they raise in taxes to finance their programs through "deficit financing". How governments spend their money and finance is called "fiscal policy". A high level of government expenditure and borrowing makes it hard for companies and individuals to borrow, this is called the "crowding out" effect. Monetary Policy

Another major factor in interest rate changes is the "monetary policy" of governments. If a government "loosens monetary policy", this means that it has "printed more money". Simply put, the Central Bank creates more money by printing it. This makes interest rates lower, because more money is available to lenders and borrowers alike. If the supply of money is lowered, this "tightens" monetary policy and causes interest rates to rise. Governments alter the "money supply" to try and manage the economy. The trouble is, no one is quite sure how much money is necessary and how it is actually used once it is available. This causes economists endless debate. Inflation Another very important factor is inflation. Investors want to preserve the "purchasing power" of their money. If inflation is high and risks going higher, investors will need a higher interest rate to consider lending their money for more than the shortest term. After the very high inflation years of the 1970s and early 1980s, lenders had to receive a very high interest rate compared to inflation to lend their money. As inflation dropped, investors then demanded lower rates as their expectations become lower. Imagine the plight of the long-term bond investor in the high inflation period. After lending money at 5-6%, inflation moved from the 2-3% range to above 12%! The investor was receiving 7% less than inflation, effectively reducing the investor's wealth in real terms by 7% each year!

What Factors Affect Interest Rates?

By Prasanna Raghavendra, eHow Contributor | updated March 09, 2011

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When companies and individuals obtain loans from the market, they are required to pay interest on the money borrowed. Lenders may compute interest rates differently. The interest rate could either be a fixed rate or it could fluctuate with variations in the market. The interest rate is determined by taking into account different factors like present market conditions, the state of the economy, the borrower's financial stability, length of the loan and the policies of the Federal Reserve.

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1. Inflation Rates
o

The inflation rate affects interest rates. When the loan is sought for a long period of time, the lender needs to safeguard its interests. With the passage of time, the purchasing power of the currency goes down. Therefore, the lender would try to recover all the money lent by charging an inflationary premium on the money lent. Thus, inflation and the rate of interest have a direct relationship. When inflation rises, interest rates also rise.

2. Market Conditions

General market conditions have the ability to influence interest rates. When the general trends in the market are good, heavy trading takes place. For trading, investors need money and seek loans. As they know that they would be able to recover their money, they do not mind paying higher rates of interest on the loans. When market activities are sluggish, investors would be wary of trading heavily and hence the lenders would not be in a position to charge high rates of interest.

Borrower's Financial Position

o

The financial situation of the borrower has a bearing on interest rates. A more financially stable borrower is able to obtain lower-rate loans. With such borrowers, there is very little likelihood of default, so lenders are willing to accept a lower return in exchange for less risk. When the lender assesses that the position of the borrower is not very sound, the lender charges higher interest in line with the risks involved.

Length of the Loan

o

The term of the loan and the rate of interest have a direct relationship. The shorter the duration of the loan, the lower the rate of interest. There is an element of uncertainty involved in loans of longer duration. Therefore, the lenders charge higher interest rates for longerterm loans.

Federal Reserve
o

The Federal Reserve can influence interest rates by setting the discount rate, the rate that banks pay for short-term loans from the Federal Reserve. It also can influence interest rates by making changes to the money supply.

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What Affects the Interest Rate?

By Katie Arcieri, eHow Contributor

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The Federal Reserve plays a key role in interest rates. The rise and fall of interest rates are affected by numerous factors including economic conditions, monetary policies and inflation. But perhaps the single biggest factor affecting interest rate fluctuations are decisions made by the Federal Reserve, which sets the overnight lending rate that banks charge each other. When the Federal Reserve lowers rates, consumers are able to borrow money cheaply and afford to buy big-ticket items more easily. Related Searches:

Rates Money Market Best Mortgage Rates in BC

1. Federal Reserve Impact on Interest Rates

The Federal Reserve buys and sells securities like stocks, which causes the nation's money supply to rise or fall.

The Federal Reserve controls the ebb and flow of the nation's money provisions. It sets policies that can increase or decrease money in banks by purchasing or selling securities such as stocks, bonds and other financial instruments. When the Federal Reserve decides to decrease money, the interest rate that banks charge one another for overnight funds tumbles. That, in turn, causes lower interest rates on loans.

2. Inflation

When consumers spend more money in the economy, retailers begin to jack up their prices because there is more demand.

Inflation has a major impact on interest rates. When more money is pumped into the economy, banks have more funds to loan. As a result, interest rates descend. But when consumers spend more money, retailers jack up their prices. When that happens, consumers may decide to hold back on their purchases.

3. Refinancing Boom

When interest rates fell in 2009, homeowners rushed to refinance to more favorable terms.

In response to the Great Recession that began in 2007, the Federal Reserve lowered interest rates to combat a sluggish home market and inject liquidity into the market. The historically low interest rates led to a refinancing boom in 2009 as homeowners sought more favorable terms on their home loans. That's because interest rates fell dramatically after the Federal Reserve announced that it would buy up billions of dollars in mortgage-backed securities. Rates stayed fairly low in early 2010. The rate on a 30-year mortgage averaged 5.21 percent during the week of April 8, 2010, up slightly from 5.08 percent the week prior, according to Freddie Mac.

4. Subprime mortgage crisis

o
road.

Many consumers locked themselves into subprime loans whose interest rates spiked down the

Many critics blame the nation's subprime mortgage crisis on extremely low interest rates. With the cheap cost of money, consumers signed up for exotic subprime loans with low interest rates that would spike after a few years. When the interest rates on those loans did spike, consumers could not afford to keep their homes and were forced into foreclosure. As a result, the home market flattened and home prices fell.

5. Fears of Government Default in Greece

U.S. interest rates are risig amid fears of government default in Greece.

As of 2010, interest rates are rising amid fears of government default in Greece. Several nations that use the euro for currency have agreed to bail out the Mediterranean country, whose stocks are falling in the midst of an economic recession. Experts expect U.S. interest rates to rise on everything from credit cards to cars.

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The Reasons That Interest Rates Rise and Fall

By Colleen Reinhart, eHow Contributor

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Think of a loan as a commodity with a price. In the United States, interest rates on loans, credit cards and investments are affected by short-term interest rate changes. According to "USA Today," the Federal Open Market Committee (FOMC), a branch of the Federal Reserve, adjusts short-term interest rates through panel voting. Their decisions have a trickle-down impact on all interest rates, impacting the cost of borrowing money. Related Searches:

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1. Borrowing Money Has a Cost

o

Just like a loaf of bread sold at a grocery store, a loan is a commodity with a cost. If something happened to the world's wheat supply and the price of bread suddenly tripled, fewer people would buy bread because of its higher cost. When dealing with loans, the cost of borrowing is the interest rate. When interest rates go up, getting a loan gets more expensive, so fewer people choose to borrow money. The Federal Reserve manipulates short-term interest rates to moderate the effects of lending and consumer spending.

Controlling Inflation
o

If interest rates weren't periodically adjusted, inflation would get out of control. Inflation is an increase in the price of goods. Low interest rates cause people to borrow and to spend more, driving up the cost of products as there are more people with money and a desire to

purchase than there are goods available for sale. A low, steady level of inflation is desirable and signals economic growth. Inflation that's too high, too low or generally unstable can have negative effects on the economy. For example, creditors don't see a return on their loans when inflation soars higher than expected. If unusually high inflation causes the cost of goods to double over the course of a year but a creditor only charges a 20 percent interest rate on lent funds, then he lost money in real terms. The 100 percent jump in prices means that the creditor could buy less than he could at the beginning of the year because the 20 percent interest charged doesn't cover the change in the price of goods. Lowering interest rates makes loans less expensive, causing people to borrow more, buy more and push up prices. Raising interest rates has the opposite effect. Stable inflation rates reduce risk for both borrowers and lenders, limit the cost to businesses of constantly repricing goods and help people living on fixed incomes to maintain a certain living standard.

Helping the Unemployed

o

During a recession, lowering interest rates helps to stimulate the economy. When interest rates are lower, more businesses and government agencies can afford the loans they need to take on new projects. These new projects produce jobs, putting more cash back into the pockets of consumers and lifting a sluggish economy out of a recession. Once more, people have the money to spend again, and the FMOC has to increase rates closer to pre-recession levels to avoid inflation.

Other Effects of Interest Rate Hikes

o

Long term, interest rate adjustments can affect the prices of stocks and other investments. The Federal Reserve notes that when interest rates are low, stocks have greater returns than bonds. Companies have more money to work with when interest rates are low, so stock buyers expect higher profits and bid up prices. However, prices can become overinflated if low interest rates make investors too optimistic. Interest rates also affect international currency markets. Rising interest rates in a country promise higher investment returns for buyers, so the relative value of the U.S. dollar tends to rise along with rates as investors purchase more U.S. currency. The value of the dollar can affect international import and export levels. Regulators have to watch the effects that rate policy is having on investments and trade to avoid a market crash or hardship for exporters.

How the Rate Is Decided and Applied Throughout the Economy

o

According to "USA Today," the FOMC consists of seven Board of Governors members nominated by the president and confirmed by the Senate. The bank president of the Federal Reserve of New York also gets a vote on the panel. Four other positions rotate among the remaining 11 regional Federal Reserve Bank presidents. The major banks adjust their prime rates based on FOMC announcements. If the FOMC raises rates and the major banks leave their lending rates unchanged, the banks see less profit. The FOMC meets to adjust rates eight times a year, with jurisdiction to change rates more often during emergencies.

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The Effects of Interest Rates on the Economy

By Edwin Thomas, eHow Contributor

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Interest rates have many direct and indirect effects on the economy. Many of these effects are described under the umbrella of monetary policy, and the few that are not are the product of government fiscal policy. Therefore, the interaction of interest rates and the economy can be traced back either to the Federal Reserve or the federal budget.

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1. Monetary Policy
o

Monetary policy is the means by which the Federal Reserve uses the supply of money and the cost of borrowing money to regulate the economy. The cost of borrowing money is better known as interest rate. While the interest rates set by the Federal Reserve are not the same as the interest rates people pay on their credit cards and home mortgages, they are related.

Expansionary Policy
o

Expansionist monetary policy is aimed at expanding credit and the money supply. It is a common tool for combating recessions, but it has been broadly the standing monetary policy of the United States since the mid-1980s, when the economic malaise known as "stagflation" was tamed. The Federal Reserve has three mechanisms for expanding the money supply. First, it can can increase the actual, real money supply. This is done not by printing money (a function of the Treasury), but by buying up bonds. Buying bonds dumps hard currency into the open market. A second tool is to reduce the reserve requirements of banks. This is the amount of capital a bank is required to keep on hand, so lowering it means they can loan out more of its capital. The third tool is to lower the discount and Federal funds rate, which is the interest charged on the short-term loans made by the Federal Reserve or between banks to meet reserve requirements.

Contractionary Policy
o

Contractionary monetary policy means contracting the availability of credit and/or the money supply. The Federal Reserve does this using the same tools, only in reverse: raising reserve requirements, raising interest rates and selling off bonds to soak cash out of circulation. The

classical target of a contractionary policy is to fight inflation, which was the standing policy of the Federal Reserve under Paul Volcker in the late 1970s to the mid-1980s.

Examples of Monetary Policy in Action

o

Paul Volcker's contractionary policy is widely credited with taming the 1970s demon of stagnant economic growth and high inflation known as "stagflation." Inflation hit a 1981 high of 13.5 percent, but had dropped to 3.5 percent by 1983, and was below 2 percent for much of the 1990s. Volcker raised the interest rates under his control to above 20 percent, which caused a severe recession, practically strangling both the construction and agricultural sectors. However, the results tamed inflation and set the stage for the more prosperous economic conditions enjoyed over the next 20 years. His successor, Alan Greenspan, pursued a mixed expansionary-contractionary policy. While broadly speaking, the period between the mid-1980s and the early years of the 21st century were expansionary in nature, with easy credit being encouraged, Greenspan had a tight policy in the late 1980s to act as a counterweight to the Federal deficit, and raised interest rates several times in 2000 with an eye on keeping a lid on inflation and deflating the speculative bubble in the stock market, particularly the tech sector. Greenspan responded to the 2001 recession with a markedly expansionist monetary policy, which was continued by his successor Ben Bernake. This very loose, expansionist policy has been blamed for the reckless lending that characterized the credit crisis and global recession of 2007 to 2009.

Fiscal Policy and Interest Rates

o

A different set of interest rates that effect the economy is the interest rates offered by the U.S. Treasury on bonds and other debt instruments. These interest rates must be sufficient to attract investors and their money, or the government will be unable to raise the cash to cover budget deficits. The more money the government needs to borrow, the higher the interest offered on government bonds needs to be, and therefore the more expensive that debt becomes. Expensive debt limits future government spending options, with a direct impact on the U.S. economy. Also, the interest offered on government debt has an indirect effect on trade relations, as foreign governments often buy up public debt to get negotiating leverage on the U.S. government. This was the practice of the Japanese in the 1980s, and the Chinese in the early part of the 21st century. By buying up cheap debt, those governments were able to force trade settlements that were advantageous to them, lest the government lose an important creditor and be forced to raise interest rates to compensate. That has a direct impact on American jobs.

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RBI likely to pause hike in interest rate

PTI Last Updated : 15 Dec 2011

MUMBAI: Amid declining growth and moderating inflation, the Reserve Bank of India (RBI) is likely to pause hike in interest rate at the mid-quarterly review of the monetary policy tomorrow.
RBI, which has raised interest rate 13 times since March, 2010 to tame inflation, may change the tight monetary stance as the industrial production has turned negative in October recording a fall of 5.1 per cent. As regards price situation, although the headline inflation has remained close to double-digit mark in November, there are signs of moderation. The food inflation, according to the data released today, fell to a nearly four-year low of 4.35 per cent during the week ended December 3. The RBI in its mid-year policy in October had indicated that it might halt rise in interest rate if the inflationary situation does not worsen. The bigger worry on the economic at this time is to arrest falling growth. "Domestically, the struggle against inflation and tightening interest rate regime has contributed to lowering of growth in demand and investment. The slowdown in industrial growth is of particular concern as it impacts employment," Finance Minister Pranab Mukherjee said in New Delhi.

State Bank of India Chairman Pratip Chaudhuri had said yesterday the he did not expect the RBI to hike interest rate in its next policy. "I don't think so because food inflation has come down significantly and steadily. RBI has said 7 per cent is the level they are targeting", he told the reporters. Besides, other experts and economists too are of opinion that RBI would pause hike in interest rate because of economic slowdown and decline in rate of price rise. Chaudhuri added, however, that he does not expect RBI to slash the Cash Reserve Ratio (CRR) as it would be contradictory to the monetary stance of targeting inflation. ICRA Economist Aditi Nayar said RBI is likely to keep the rates unchanged because though food inflation has fallen, manufactured products inflation still remains at an elevated level of 7.7 per cent. "With inflation related to non-food manufactured products rising in November, 2011, RBI is expected to leave the repo rate and the CRR unchanged in the upcoming mid-quarter policy to continue to dampen inflationary expectations," she said. The country's GDP expanded by a meagre 6.9 per cent in the second quarter of the current fiscal, the lowest in over two years. India Inc has blamed the rate hikes, which have increased the cost of borrowings, for hindering fresh investments and slowdown in industrial activity. "We think the RBI will go for a pause. It is still too early to reverse the rates. Manufactured inflation still remain above 7 per cent and is likely to remain high as rupee depreciation has made imports expensive. "We expect rate cuts to come in the first quarter of 2012," Crisil Chief Economist D K Joshi said. Industry bodies like CII and Ficci have already called upon the RBI to cut rates for ensuring industrial revival. According to Goldman Sachs, the negative growth in IIP numbers increases the probability of an early reserve requirement cut by RBI. "Our current expectation remains that the RBI will continue to inject liquidity through open market operations, then cut the reserve requirement ratios of banks in January, followed by repo rate cuts in March, 2012. We continue to expect the RBI to cut policy rates by an above-consensus 150 bp in 2012," Goldman Sachs said in a report.