Competitive Analysis and Business Cycles - Assignment Example

Influences on Interest Rate What major economic indicators would you examine if you were planning to make a large purchase and needed a loan? Forexample, think about buying a new car, some business equipment or a house? The cost of acquiring a loan is the interest rate at which the loan is offered to the consumer. If the interest rate is low at the time the loan is secured, then the consumer stands to save a lot of money through out the payback period of the loan. Several key factors influence the interest rates in the market. The real interest rate which takes in to account the level of inflation in the market is influenced by: a) the level of household savings in the economy b) the demand for capital by business entities for expansion and new investments and c) the amount of funds invested or demanded by the government through its fiscal policy. If interest rate behavior is to be predicted, then the inflationary trends of the economy as to be observed, as these two variables are interdependent. Following are the key economic indicators which can be used in predicting the inflation rates and the interest rates (Woodruff, 2001). The Department of Labor employment report – if this report indicates tightening labor market conditions and increased pressure for higher wages, then it can be the basis to predict that inflation will increase resulting in high interest. The quarterly worker productivity report – This report provides information on worker productivity. If the data indicate low productivity, then rising inflation will be a resulting factor that in turn increases the interest rates. If workers work harder at high wages, the inflationary pressures are offset. The gross domestic product (GDP) – If economy is growing fast and GDP is rising too fast the economy stands the risk of over heating. This can be used as a guide to forecast high inflation and high interest rates. The employment cost index (ECI) – Pressure for high wages is an indicator of rising inflation and high interest rates. The consumer price index (CPI) – the most commonly cited measurement of inflation. The CPI is the price of a basket of goods and services that consumers purchase. When inflation is high, price levels rise in reaction to higher demand. This too increases the interest rates. The producer price index (PPI). Similar to CPI it will give a trend of inflation rates which can influence the interest rates. By analyzing the above mentioned economic indicators, consumers will be in a good position to gauge the inflationary status of the economy and the resulting upward or downward movement of the interest rate. By analyzing this movement, they can plan the timing of seeking loan financing to be either before the interest rise or after the interest rates fall. 2. Describe how the Federal Reserve’s policy-makers can influence interest rates. When a government uses a monetary policy to regulate the economic activities, it is carried out through a designated independent body such as Federal reserve. Fed uses various monetary tools to influence the interest rates by manipulating the money supply within the market.. An increased money supply will lead to low interest rates. The interest effect will lead to increased investments, increased spending via credit cards and other borrowed purchase modes, as well as increases wages via the employment effect stemming from increased investments. When the interest rates are rises the cost of capital increases which reduces the propensity of business people to invest more. In effect, increase in interest rates will result a reduction in investments. However, when interest rates decline, the cost of capital will reduce, increasing the attractiveness of borrowed funds for investments such as business expansions or starting up new businesses. At individual level, people will be more inclined to spend than save when interest rates are low. On the other hand, if the money supply is reduced, then there will be excess demand for money which will increase the interest. Federal Reserve can influence the interest rate in the market through three main tools. These include changing of the Required Reserve Ratio; changing the discount rate or the prime lending rate or via open market activities (Anderton 2002). Fed can influence the interest rate by manipulating the “prime lending rate” of the Federal Reserve Bank. If the rate is increased then this will increase the cost of funds borrowed by commercial banks and they will in turn increase interest rates when they offer credit facilities to customers. On the other hand, if the prime lending rate is reduced, then commercial banks will borrow more and offer at lower interest rates to the public. The interest rates can be influenced through the manipulation of the Reserve Ratio by the Fed. This is the percentage of depositors balances which the banks are expected to have on hand as cash. The Federal Reserve can change this rate depending on whether it wishes to increase or decrease the interest rates. If the objective is to reduce the interest rate, then the money supply has to be increased which will create excess supply, causing the “price” of money which is interest to fall. When the ratio is lowered, the banks can lend out more funds, increasing the money supply (Prescott, 1986). Fed can also influence the interest rates by engaging in open market operations. These include buying and selling of various credit instruments such as government bonds, debentures and foreign currencies or commodities. If they sell more government bonds for example, the money supply in the market will contract. This will in turn increase the interest rate. To anticipate the Fed’s moves in reducing or increasing interest rates, it is necessary to monitor the inflation in the economy. In the eyes of an economist, too much of economic development termed as “overheating” is as undesirable just as a market in depression. Thus the Fed will continue to change back and forth between high interest and low interest monetary activities to keep the market in equilibrium. . 3. Do you think prospects for changes in Fed policy would affect your decision to make a purchase that requires financing? Explain. If there is knowledge of prospective changes in Fed’s monetary policy, then consumers will make use of such information to time their borrowings or schedule purchases funded by burrowed finances. A change of Fed’s policies can either increase the current interest rates of borrowing or decrease it. If the current inflation rates are high, it is likely that the Fed will carryout activities that are aimed at reducing the money supply in the market to reduce inflation. When there is reduced money supply, the interest rates will rise (Anderton 2002). When such prospects for changes is anticipated, it is wise to apply for the loan or make the purchase on borrowed finances on immediate basis before the Fed’s activities influence the interest and make it go higher than the current rate. However if the inflation levels in the market is low, and the market is undergoing depression, Fed will implement policies that will increase the money supply in the market so that investments will increase, employment will increase and propensity to spend will rise. This will reduce the rate of interest as there is excess supply of money in the market. In a situation where a consumer can forecast such actions by Fed, it is wise to wait until the changes are implemented and the interest rates reduce to apply for a loan or make purchases on borrowed finances (Woodruff, 2001). References: Woodruff, T. (2001) The Basics - A borrowers guide to forecasting interest rates. Retrieved on 12.10.2008 from http://moneycentral.msn.com/content/Investing/Realestate/P39219.asp Anderton, A (2003) Economics. 3rd ed. London: Causeway Press Limited. Harrod, R.F. (1936) The Trade Cycle: An essay. 1961 reprint, New York: Augustus M. Kelley. Prescott, E. (1986) “ Theory Ahead of Business Cycle Measurement” FRB Minneapolis Quarterly Review. Mark Blaug (1985). Economic theory in retrospect. Cambridge, UK: Cambridge University Press. Read More