Entries Tagged 'interest-rates' ↓

Readers Question: Could u pls explain to me how the volume of private investment depends on the rate of the interest and marginal efficiency of capital?

Private investment is an increase in the capital stock such as buying a factory or machine. (investment in this context does not relate to saving money in a bank.)

When firms and individuals decide how much investment to make interest rates and marginal efficiency of capital are important.

Interest rates. If interest rates are high then it makes it expensive to borrow money. This will deter investment because investment is often financed through borrowing. Also when interest rates are high it makes it more attractive to save money. Investment is often financed out of retained profit. High interest rates mean that investment is relatively less attractive than saving money in a bank.

• Assuming inflation is zero, and interest rates are 3%. Then any investment project would need an expected rate of return of at least greater than 3%. If interest rates were 6%, then any investment project would need an expected rate of return of at least greater than 6%, and therefore less investment would occur. Continue reading →

Yesterday, the Bank of England released its inflation forecasts for 2008 and 2009. It suggests that if base rates are kept at 5.25% then inflation will stay close to 2%. However, if they cut interest rates to 4.5% (as many in the City have been predicting) then inflation is likely to breach the 3% target.

The Bank, therefore, have a difficult balancing act. On the one hand we have rising inflation (from cost push factors, especially food and energy) but we also have a slowing economy.

Although, the Bank are keen to point out the weaknesses of the economy, they seek to avoid the gloom that has surrounded some sectors of the economy. The Bank suggest this year may merely invovle a rebalancing. Sectors that have done well previously will be slowing down. These sectors include:

1. Housing Market
2. Financial sector in city of London
3. Mortgage lending
4. Consumer Spending

However, other sectors which have struggled in the past, could do better in the coming years. These sectors include:

Manufacturing, export sector.

The inflation forecast also came out on another good day of employment figures, with falls in unemployment.

For more details see:

• Mortgage interest rate forecasts
• Bank of England Inflation forecast 

Readers Question: Interest rates are determined by the markets and not by the Bank of England-where’s the truth?

An interesting question.

Firstly, it is worth bearing in mind that there are different interest rates in an economy.

Bank of England Base Rate. This is the most important interest rate because it is the rate at which other commercial banks need to borrow from the Bank of England. Therefore, the base rate is an important determinant of other rates in the economy.

Generally, speaking the Bank of England is free to set base rates to achieve its target of low inflation CPI 2%+/-1. At certain times markets may pressurise the Bank of England to change rates, but largely the Bank of England is free to set rates depending on how it sees fit.

• ERM crisis. in 1992, the government increased interest rates to 15% to try and protect the value of the £ (which was then in the ERM) However,  the markets felt this interest rate was unsustainable in a recession. Therefore, people continued to sell pounds effectively forcing the £ out of the ERM and making the UK cut rates. This is an example of market forces forcing the monetary authorities to change interest rates, but, it is relatively rare.

Continue reading →

Earlier today, I wrote about the effect of the stock market on the economy. One thing I forgot to mention is the effect of the stock market on Central Bankers.

The Federal Reserve were supposed to meet on January 29th, where markets expected a 0.5% cut. However, the Fed decided to have an unscheduled meeting and cut interest rates by 0.75%.

Graph of US Interest Rates

It appears the main motivation behind this ‘panic’ measure is to prop up falling stock markets.

However, with market sentiments pessimistic, this cut to boost confidence may misfire. Firstly, was it really necessary to bring the rate cut forward by one week? Why were interest rates cut by 0.75%? A suspicious Wall Street may ask do the Fed know something we don’t know? (Wall Street fell by 400 points after the announcement)

I wrote some of the economic effects of this recent rate cut on the US economy here

Although the Housing market is creating serious economic problems, the Fed have a reputation for over reacting to stock market concerns. It will be interesting to see whether they can get it right this time.

Problems of Cutting Interest Rates 

Desperate Measures at Economist 

Readers Question: What is  Amortisation ?

Amoririsation is the running down of a loan through regular payments. A good example is a capital repayment mortgage. In this case the homeowner pays monthly installments paying both interest on the loan and also capital repayments. This means that after 30 years the loan will be paid off.

The opposite of amortisation is an interest only mortgage. With an interest only mortgage, only interest payments are made. This means that the capital debt of the loan remains. Usually, with an interest only mortgage the borrower is required to find an alternative investment plan to be able to pay off the debt.

See also:

• Interest Rates explained 

The interest rate cycle is closely related to the economic or trade cycle.

Interest rates are the main mechanism of influencing economic activity. For example, in the past few months retail activity in the UK has slowed down, therefore, many have been calling for interest rate cuts to stimulate domestic demand.

Since 1997, UK interest rates have been fairly steady, the interest rate cycle has been less volatile. However in the 1980s, under the Thatcher government the interest rate was much more volatile due to the economy being subject to periods of boom and bust.

Diagram of Interest Rates in the UK

Source: BBC website – Thatcher years in pictures

Note the two periods of very high interest rates in 1980 (17%) and 1990 (15%) were followed by recessions.

On both occassions interest rates were increased to reduce inflationary pressure. In 1990, interest rates were also increased to protect the value of the Pound Sterling in the Exchange Rate mechanism. Continue reading →

Gross interest rate This is the total interest payable before any deductions such as tax and charges. For example the gross interest rate on a savings account may be 4.25%

Net Interest Rate. This is the total interest payable after any deductions. For example in the UK, the net interest rate will be the gross interest rate – basic rate of income tax. Therefore, if the gross rate is 4.25%, the net rate will be 3.40%.

Gross AER. This is the Gross Annual Equivalent rate. This applies to all accounts where interest rates are paid more frequently than once a year. The significance of this is that if you are paid interest every month, you have a chance to earn interest on the interest payments you gain in the first month. If interest is calculated daily the cumulative benefit will be greatest. Therefore, the Gross AER, will be higher than the gross interest rate. Typically interest is credited monthly, quarterly or in rare cases daily.

• Interest Rates explained
  
• Effect of Increasing Interest Rates

Readers Question: What is the effect for increased interest rate on country and depositors

I have answered this question a few times before:

• Interest Rates explained 
• Effects of increased interest Rates 
• An Essay on the effects of higher interest Rates
  

I don’t want to repeat what I have already written so will just make a few ‘new’ observations.

Higher interest rates increase the cost of borrowing and make it more attractive to save. This is likely to reduce consumption and reduce the rate of economic growth.

However, there is also an income effect of higher interest rates. As interest rates increase, savers (people who have deposits) will see an increase in interest rate payments. – Basically, saving has a higher reward. Therefore, savers see an increase in disposable income this could actually cause an increase in consumption.

However, in the UK, the savings ratio is very low. The UK has high levels of personal debt. Therefore an increase in interest rates will reduce the disposable income of people with mortgages and debt. This will outweigh the increased incomes from depositors. In the UK, higher interest rates have a particularly big effect in reducing consumer spending because of the size of mortgages.

Generally, interest rates are used to control inflation. Higher rates are used to reduce inflationary pressures. The UK economy is particularly sensitive to interest rate changes.

Higher interest rates also make it more attractive to save money in the UK, as opposed to other countries. Therefore, higher rates will cause ‘hot money flows’ and may cause the value of the £ to rise.

Readers Question: In general what do commercial banks receive their higher interest rates from?

I’m afraid I don’t really understand this question. But, I will make these points.

Commercial banks will lend money at a higher rate than they pay to savers. This difference in interest rates enable them to make a profit. For example, if you went to a commercial bank such as Natwest, Halifax or HSBC, they may charge you 7-8% for a loan. These tend to be the highest interest rates commercial banks will charge. If, however, you borrowed on a credit card, the interest rate may be 16%.

Interest rates on savings can vary from practically 0% to 4-5%. For the highest interest rate, savers will probably have to commit to saving for a certain length of time. They may have to give a months notice before withdrawing the money.

Commercial banks, borrow from the Bank of England. This is because the Bank of England acts as lender of last resort. This interest rate is known as the Repo rate or ‘base rate’

• Interest Rates explained
  
• Why are there so many interest rates?
• Interest Rate Forecast

I’ve been studying economics for 13 years and I still get confused at the bewildering array of interest rates. Basically, interest rates can range from anywhere between 0% and 2,316%

The most important rate is the base rate (sometimes referred to as the repo rate). This is the rate set by the Bank of England. (In US by the Federal Reserve). This is important because it determines the rate at which banks borrow money from the Bank of England. Therefore, if the Bank of England changes the base rate the commercial banks, like Natwest and HSBC will alter there interest rates accordingly.

• Current account rates. This tend to be low, e.g. 1%. This is because you can access the money at any time. Therefore, for these account, the banks have to keep a greater % of cash in the bank for when people wish to withdraw money.
• Savings Account rates. These tend to be higher e.g. 4%. The banks are willing to pay higher interest rates because they are less likely to have deposits withdrawn. Continue reading →