Money and Interest Rates - Essay Example

Money and interest rate case assignment 1. What major economic indicators would you examine if you were planning to make a large purchase and needed a loan? For example, think about buying a new car, some business equipment or a house? Monetary policy is an important aspect of overall macro-economic policy. To influence economic conditions or to achieve economic objectives, monetary authorities employ various techniques. Money is a major facilitator and motivator for all economic activity relating to consumption, production, exchange and distribution. Money serves as a medium of exchange, as a store of value, a standard for measuring values and a unit of account. The role of money is to serve as a medium of exchange, ad it is the medium through which everything can be bought and sold. Whenever a large purchase is planned or there is a need for loan, numerous economic indicators are examined. A few of them are inflation, interest rates, Gross Domestic Product (GDP), exchange rates and unemployment rate etc. Inflation is one of the most important indicators that are to be examined because inflation is the persistent rise in general level of prices of goods and services in an economy. When the prices of petrol, diesel and essential commodities like rice, wheat, cooking gas go up and people spend more money for the same goods and services then it is inflation. Essentially inflation indicates that the value of money is going down and it takes more money to buy the same basket of goods. The GDP is a harder indicator to read because it measures how much our domestic economy is producing. Generally, though, economists worry that if the economy grows too fast, price inflation will increase, and so will the interest rates that we earn and pay (Woodruff). Interest rates are important to consider because they influence the volume of savings in an economy. They also determine the volume of investment in an economy. If the rate of interest is lowered, a businessmen and industrialists will come forward to borrow more and expand their investment. Expansion of investment by industrialists promotes economic growth. Interest also determines the marginal efficiency of capital and influence the movement of capital along with the level of business activity. 2. Describe how the Federal Reserve’s (Fed for short) policy-makers can influence interest rates? Most money is created via private loans. The Federal Reserve's job is to make sure the private world keeps loaning money. Some of the most powerful tools that the Federal Reserve used to keep the money flowing in the economy are Open Market Operations, Reserve Requirements and the Discount Rate are the Federal Reserve’s tools for keeping the money flowing. The outflow of money by the Federal Reserve by any of these means would definitely equate to the inflation in future. The discount rate is the interest rate the Federal Reserve charges banks if banks borrow reserves from the Federal Reserve itself. The discount rate is often changed along with the discount rate, but the change does not have a very important effect. Banks are required to hold a portion (either 10 or 3 percent of most deposits, depending upon the size of the bank) of some of their deposits in reserve. Reserves consist of the amount of currency that a bank holds in its vaults and its deposits at Federal Reserve banks. If banks have more reserves than they are required to have, they can increase their lending. If they have insufficient reserves, they have to curtail their lending or borrow reserves from the Federal Reserve or from another bank that may have extra, or what are called excess, reserves. The requirement is seldom changed, but it is potentially very powerful (Economics Minute). The market goes down because the money outflow equates to inflation and the people with money to invest are concerned that future inflation coupled with taxes will outpace the individual benefits from investing in a business activity. The investors are moving to real items such as gold. Therefore, when the Federal Reserve lowers rates, the private loans continue to shrink and jobs shrink. This situation can be broadly defined as stagflation. Stagflation is an economic situation in which the economic growth is very slow and there is rising unemployment. When the Federal Reserve announces a change in interest rates, then it is referred to as the Federal funds Rate. This is the rate that member banks pay for overnight loans to each other. The announcement is really of the target rate which the Federal Reserve plans to achieve. The Federal Open Market Committee will change its operations to buy or sell T-Bills on the Open market until the target rate is achieved. Since the Federal Funds rate is typically the cheapest money a bank can borrow, it tends to be the floor for all other bank interest rates. 3. Do you think prospects for changes in Fed policy would affect your decision to make a purchase that requires financing? Explain. Prospects for changes in the Federal Reserve Policy would definitely affect a consumer’s decision to make a purchase that requires financing. If banks have fewer reserves, they cannot make as many loans. The reduction in loans and the resulting higher interest rates discourage business and consumer borrowing and spending. In the case of too little growth or a reduction in business and consumer spending, the increased availability of loans and lower interest rates may encourage businesses and consumers to increase their spending. Bibliography Economics Minute. the Federal Reserve System and the Monetary Policy. 6 November 2002. 21 May 2008 . ICFAI Center for Management Research (ICMR). Economics for Managers. Hyderabad: ICFAI Center for Management Research, 2003. Woodruff, Tom. A borrower's guide to forecasting interest rates . 23 June 2007. 21 May 2008 . Read More