Can Decrease the Interest Rates in a Country Help to Flagging Economy - Research Paper Example

Interest Rate and the Economy Introduction: The basic purpose of this paper is to understand the whether the notion that decrease the interest ratesin a country can help give wind to its flagging economy holds any truth or not It has been a generally accepted notion that interest rates are macroeconomic factors that can altered directly by governmental intervention and we need to determine that an economic factor that was so easily convertible could have such deep and direct effects on the economy or not and how much does its easy manipulation will play a part in the said channel to the macroeconomic factor. Finally, we would like to put this notion to rest whether unilaterally decreasing interest rates regardless of the conditions in the country will always aid the economy or whether it has become merely an opt-practiced procedure which doesn't have the effects it was expected to have or he surveyors hoped to attain when they began recording perceptions of market analysts with regards to the topic at hand. Now, the ability to ascertain credit at reasonably favorable terms i.e. good interest rates is something that households and businesses alike, regardless of their area of participation, must do themselves without any outside party determining or even influencing the terms of the final agreement between the borrower and the lender. Now, the floor interest rates which are present in the world and especially in our country initiate the process of the full recovery of the economy, however, it is distinctly important to understand that an easygoing and overtly mundane or banal economic recoil makes market analyst ponder over the notion that whether interest rates happen to be a factor that is critical enough in size and important than it can actually steer an entire economy without assistance or fail. If we conduct a thorough historical analysis of the world economy since the turn of the century, we will notice that the current recession which is ravaging the global economy has been caused by a number of reasons, all of whom have been aired and given enough attention over this period, however, a critical factor in the downfall of a dynamic and well performing global economy have been a string of interest rate augmentations in 1999 and 2000. Given the fact that increasing the interest rates could certainly put to an end the promise of a burgeoning economy which has the potential to expand and influence the global economic, then it is important to note that the opposite of the above statement must also be true and should be put forth as an completely independent notion which states that decreasing the interest rates of the country could certainly boost an ailing economy and provide it with the impetus that it requires to rebound its way towards recovery and re-establishment. This way of reasoning, however, is not completely fool proof and without any loopholes. The real analogy that can be used, or perhaps that should have been used in this case is that the difference between the two is pulling on a rope and pushing of the rope in the two cases which we have just explained earlier; here pushing the rope is the instance of lower the interest rate in order to jumpstart the economy and boost its performance during a period of regression or stagflation. The recovery of the economy in 2004 has moved onto such a mature stage at the point when the author was formulating his opinion on the said matter that actually empirically showing whether we can ascertain that decreased interest rates were the reason that first immunized the economy and then brought the economy back from the dead to life, all against a backdrop of a general contamination of the economic melancholy that was being experienced at the time Professor Larry Allen was formulating his piece on the correlation between interest rates and the revival of an economy. Theoretical framework: A lot has been said about the interest rates and the economy in general but we have not discussed the theory of this specific occurrence as yet. Here, we will try to look at the theoretical part of this notion. Now, the interest rate is basically the cost that is associated to borrowing of any amount of principle capital in the economy. Now, when the interest rates are reduced, the cost of borrowing naturally falls down as the overall repayment for a specific capital is not as large as it was before due to decreased interest payments. Therefore, a move like this would encourage more people to save less money and spend more of it as the incentive to save i.e. putting the money in the bank and collecting the interest rate would remain as high as it was before. In addition, this move would also encourage people to take out loans for personal spending; a phenomenon which we have seen in the housing market where people increased their spending in housing when the Federal Reserve cut the interest rates in the country. This is again due to the fact that the cost of borrowing now is less than before so a house would not cost as much in the decreased interest rate regime. Now, due to this increased spending in the country, the overall economic product in the country would also increase, hence, the overall economy would gain pace and create a greater level of output. Therefore, just by reducing the interest rate, the economy can move away from a period of stagnation and start producing more output; an action which helps it recover from any recessionary implications present in the country. Let us now look at the theoretical framework with a more economic approach. The first and foremost factor that we will would be the affect of the decreased interest rate on the aggregate demand of the country. Now, when interest rates would be slashed, people would have greater spend able income as we have explained earlier, which would increase consumer demand and planned investment. Now, the more important thing to take note here is that relation between the interest rates and the general price level in the country. Now, we can safely say that interest rates, for the purpose of this argument can be considered to be the cost of handling money. Now, if we assume that the money supply in the economy is fixed, as in line with the major economic theories, an increase in the price level would lead to a decrease in the real income of people in the country due to which money would have to be borrowed from external sources in order to maintain their level of real income before the increase in price level. However, as we have already stated that the money supply into the economy is fixed, therefore, there will be a greater demand for money and a lesser supply. Due to this the cost associated with acquiring money would go up, hence the interest rate in the country would go up as well. However, in the converse that interest rates are slashed the aggregate demand would shift be expected to shift equivalent to the shift in the interest rates which would not see a great change in the price level and the central would be able to fulfill its desire of boosting the economy by increasing aggregate demand. Source: http://tutor2u.net/economics/content/topics/ad_as/ad-as_notes.htm Conclusion: The statement that has been put forward to us is not as simplistic as it appears; in that there a far greater number of variables in play here than merely interest rate and the output of a flagging economy. We have already discussed that the different sectors in a country are intertwined and some factors that directly affect one sector might indirectly affect another, therefore, it is important that we take the statement on its face value and merely try and answer the question at hand rather than get into the depth of what this statement implies to us. For this matter, we can conclude that there has been ample evidence in the past in the different economies around the world to suggest that what is being suggested by the topic at hand is indeed true; something which have been able to back with its theoretical application. Therefore, we do concede that this statement is not representative of an active model but what it entails is a concept which we accept at least for the global economy at the current point in time. However, the most important question is that will this tactic work: will people actually increase their investments and spending to increase aggregate demand and move people out of the economic quagmire. Well, that has a lot to d with the confidence that people place in the central bank i.e. if people believe that their policy making is workable and can lead to better economic conditions; then they can be certainly expected to do what the central bank asks them to do. However, if the central bank has lost the confidence of the population due to earlier mistakes, than ascertaining the economic acceleration would result from this interest rate slashing of 5% to 1% is something that cannot be categorically stated as something that will happen over the course of time. Bibliography: 1. Allen, Larry (2004) "Did Lowering Interest Rate Actually Help the Economy" Lamar University. Available at www.tracer2.com/admin/uploadedPublications/1235_AskExpert_InterestRates_edit.pdf [Retrieved on April 9, 2009] 2. Annicchiarico, Barbara and Marini, Giancarlo (2006) "Interest Rate Pegs, Wealth Effects and Price Level Determinacy", Metroeconomica, VL: 57, NO: 4, PG: 521-535, University of Rome Tor Vergata, Available at http://dx.doi.org/10.1111/j.1467-999X.2006.00254.x Read More