Interest Rates In The Economy

Interest Rates in the Economy

It has been an experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate day-to-day financial decision-making (Greenspan). This quote is from Allan Greenspan, the Chairman of the Federal Reserve Board who was arguably the most powerful man in the world. Greenspan was also extremely financially intelligent. Being financially knowledgeable is essential in surviving in the financial world today. Even more important is educating ourselves about interest rates because they play a huge role in our economy. I believe higher interest rates will improve the economy. Higher interest rates make it harder to borrow money, and in effect the value of the dollar increases and inflation goes down.

Interest rates are the cost of borrowing money, expressed as a percentage, usually over a period of one year. Just a few items that have interest rates are mortgages, automobiles, and credit cards. An interest rate is the amount of money a borrower must pay the lender on top of the amount being borrowed. In the last ten years, interest rates have been moving up and down like a roller coaster. According to a report by the Federal Reserve Board, the interest rates in the last ten years have not remained still for more than one year. During 1990 the interest rates were at an all time high at around eight percent, nearly double the amount today. From 1991 to 1994, the rates dropped to a significantly low three percent. Starting at the end of 1994 up to the turn of the millennium, interest rates have jumped up to, and remained between, five and six percent. By June of 2003, the rates had dropped to an extremely low one percent. Since then, the rates have increased and are currently at five and one half percent (Federal Reserve Board). That is just a glance at the interest rates fluctuation in the last ten years.

Interest rates began in 1913 when the Federal Reserve Board was created. The Federal Reverse Board is a group of seven highly intelligent individuals, and essentially decides the interest rates for the people of the United States. "The most important job for them to do is to set the federal funds rate, which is what banks pay each other for overnight loans" (FunAdvice). The Federal Reserve Board actually changes what we call the federal funds rate. The federal funds rate is simply a target rate of what the interest rate should be, not actually the interest rate itself. However, the rate the Board does set is very close to the interest rate, or the actual rate consumers pay (Merriman 1).

There are three main reasons why interest rates change. The first reason is supply and demand. If the demand for borrowing money is higher than the lender has available, the rates will increase. This would happen if the interest rates were raised during a low time in the economy. People then have no choice but to still borrow money. However, if there is not a demand for borrowing money, then the lenders will be competitive, lower their rates, and try to draw in anyone they can get.

Inflation is another factor in the fluctuating interest rates. When inflation goes up, the interest rates follow because the lenders, such as bankers need to still make their money. Inflation affects interest rates in the same way it affects things like gas, food, or real estate.

Another reason is because the economy is growing too quickly. Interest rates are raised to slow down the borrowing of money. Therefore, an economy that grows too strong and too quickly will result in high interest rates on real-estate prices, higher rents on apartment, and higher mortgage rates. For example, "after September 11, 2001, the economy went down" (Baker). The Federal Reserve Board then reduced the interest rates in order to help the economy because it allowed more people the ability to afford homes. Now that time has passed and the economy is out of the post 9-11 period, the rates are slowly and steadily rising again (Why Interest Rates Change). Here are some of the effects interest rates have on our economy.

Economic Event Effect on

Interest Rates Significance of event

Consumer Price Index (CPI) Rises

Indicates rising inflation.

Dollar Rises

Imports cost less; indicates falling inflation.

Durable Goods Orders Increase

Indicates expanding economy

Gross National Product Increases

Indicates strong economy

Home Sales Increase

Indicates strong economy

Housing Starts Rise

Indicates strong economy

Industrial Production Rises

Indicates strong economy

Business Inventories Rise

Indicates weak economy

Leading Indicators (LEI) Increase

Indicates strong economy

Personal Income Rises

Indicates rising inflation

Personal Spending Rises

Indicates rising inflation

Producer Price Index Rises

Indicates rising inflation

Retail Sales Increase

Indicates strong economy

Treasury Auction Has High Demand

High demand leads to lower rates

Unemployment Rises

Indicates weak economy

(Why Mortgage Rates Change).

As stated earlier, interest rates are essentially set by the Federal Reserve Board, currently led by Chairman Ben Bernake. Even though the board sets a target rate, banks, auto dealerships, and credit