Interest rate and economy
As India Overheats, Mind Your Fingers
If you read the business section of a paper, you would occasionally come across reports like this with a lot of talk about interest rate and inflation. If you wonder what is going on, read on:
What is interest rate
Interest rate is the cost of money. Higher the interest rate, it costs more to borrow money. Interest rate is one of the most important tools central banks use to keep the economy in check. It is used to both get the economy out of recession (like US dropped the interest rate to 1% during 2002, or India pushing the interest rate upwards of 6.5% to check overheating of economy). Interest rate is actually used to control money supply, along with a few other tools like Cash Reserve Ratio (CRR). While the interest rate and CRR are just tools, the central banks are really trying to control the Money Supply.
What is Money Supply
Money Supply is the money available to you and me (households) and firms to purchase stuff. It is all the money out in the market plus the deposits in the banks. Money Supply actually affects or captures the mood of households. If you think you have more money (like in a growing economy), you may end up buying a new car or a new house or invest heavily in stocks (or worse speculate). Similarly less money would make you more careful and you may not start a new business which ordinarily you would have in a robust economy. Bottomline, it is the lubricant which keep the economy moving. Too little and the economy will freeze, too much and it will drown.
Money Supply and GDP
The money supply in an economy should be proportional to the Gross Domestic Product (GDP). GDP indicates the value of all the work (goods and services) we did in a year. Intuitively it makes sense that the amount of money flowing in an economy should be proportional to the actual activity taking place in the economy. If money supply is high/low in respect to GDP then it affects the health of the economy.
Unfortunately while GDP affects the money supply in a good way, the markey mood can affect an economy negatively. Consider speculation. Assume that speculation has driven up the price of your stocks. You think you have lots of money. The interest rates are low (say 2%). It makes you go out and buy a new house, new car, land, start a business, stuff you may not have done had the interest rates were high.
The ugly face of inflation
So, what is wrong in having lots of money. Well, the chances are, everyone else has lots of money too. But the goods and services are same in number. Lots of money, limited goods, it will drive up the price. You have inflation.
Inflation is bad for a number of reasons. To start with, you stop being competitive to the rest of the world since your goods cost more. Second, businesses lose profit. Their operatioal costs increases and profit margin decreases. Also, the "actual" interest you are earning on your money is less. For example, if you are getting 6% interest in your investment, and inflation has increased fronm 2% to 7%, you would be able to do less with the interest you would get.
Cenrtal Bank intervention
Central Banks don't like this high inflation and increasing interest rate is one of the tools they use to curb inflation.
How does the central bank increases interest rate? The central bank is going to affect the money supply in the market (by pumping or withdrawing money, which it does by buying/selling bonds), to effectively up the interest rate charged by one bank to another bank so that interest rate is near the target rate whic central bank is comfortable with.
Finally consider this example for a complete picture: The existing interest rate is 5% set by the central bank. This is the approximate rate at which banks lend money to one another. This is the price of money. Lets say inflation is high. Everyone thinks they have lots of money and some are making reckless decisions. It is time for the central bank to step in. To curb inflation, it raises target rate by 25 basis points (that is by 0.25%). The new target rate is 5.25%. Central bank wants to make money costly. The way to do is withdraw money from market. That is, reduce money supply. Central Bank issues Bonds. You buy a bond by paying money to the central bank and get a guarantee that you will be paid the money back at maturity with some interest. This reduced money supply increases the price of money or the interest rate which banks will charge for a loan. At the same time, they may pay higher interest rate on the money deposited with them.
The increased interest rate has big effects. In stock market, there is less money, less to invest in stocks, hence prices of stock go down. Increase in housing loan rate will damp the realty market. A big negative effect can be that people will not borrow money to start businesses or expand existing business. We don't want that to happen either. That is why central banks increases interest in small increments, to make sure you don't feel the jolt.
If you read the business section of a paper, you would occasionally come across reports like this with a lot of talk about interest rate and inflation. If you wonder what is going on, read on:
What is interest rate
Interest rate is the cost of money. Higher the interest rate, it costs more to borrow money. Interest rate is one of the most important tools central banks use to keep the economy in check. It is used to both get the economy out of recession (like US dropped the interest rate to 1% during 2002, or India pushing the interest rate upwards of 6.5% to check overheating of economy). Interest rate is actually used to control money supply, along with a few other tools like Cash Reserve Ratio (CRR). While the interest rate and CRR are just tools, the central banks are really trying to control the Money Supply.
What is Money Supply
Money Supply is the money available to you and me (households) and firms to purchase stuff. It is all the money out in the market plus the deposits in the banks. Money Supply actually affects or captures the mood of households. If you think you have more money (like in a growing economy), you may end up buying a new car or a new house or invest heavily in stocks (or worse speculate). Similarly less money would make you more careful and you may not start a new business which ordinarily you would have in a robust economy. Bottomline, it is the lubricant which keep the economy moving. Too little and the economy will freeze, too much and it will drown.
Money Supply and GDP
The money supply in an economy should be proportional to the Gross Domestic Product (GDP). GDP indicates the value of all the work (goods and services) we did in a year. Intuitively it makes sense that the amount of money flowing in an economy should be proportional to the actual activity taking place in the economy. If money supply is high/low in respect to GDP then it affects the health of the economy.
Unfortunately while GDP affects the money supply in a good way, the markey mood can affect an economy negatively. Consider speculation. Assume that speculation has driven up the price of your stocks. You think you have lots of money. The interest rates are low (say 2%). It makes you go out and buy a new house, new car, land, start a business, stuff you may not have done had the interest rates were high.
The ugly face of inflation
So, what is wrong in having lots of money. Well, the chances are, everyone else has lots of money too. But the goods and services are same in number. Lots of money, limited goods, it will drive up the price. You have inflation.
Inflation is bad for a number of reasons. To start with, you stop being competitive to the rest of the world since your goods cost more. Second, businesses lose profit. Their operatioal costs increases and profit margin decreases. Also, the "actual" interest you are earning on your money is less. For example, if you are getting 6% interest in your investment, and inflation has increased fronm 2% to 7%, you would be able to do less with the interest you would get.
Cenrtal Bank intervention
Central Banks don't like this high inflation and increasing interest rate is one of the tools they use to curb inflation.
How does the central bank increases interest rate? The central bank is going to affect the money supply in the market (by pumping or withdrawing money, which it does by buying/selling bonds), to effectively up the interest rate charged by one bank to another bank so that interest rate is near the target rate whic central bank is comfortable with.
Finally consider this example for a complete picture: The existing interest rate is 5% set by the central bank. This is the approximate rate at which banks lend money to one another. This is the price of money. Lets say inflation is high. Everyone thinks they have lots of money and some are making reckless decisions. It is time for the central bank to step in. To curb inflation, it raises target rate by 25 basis points (that is by 0.25%). The new target rate is 5.25%. Central bank wants to make money costly. The way to do is withdraw money from market. That is, reduce money supply. Central Bank issues Bonds. You buy a bond by paying money to the central bank and get a guarantee that you will be paid the money back at maturity with some interest. This reduced money supply increases the price of money or the interest rate which banks will charge for a loan. At the same time, they may pay higher interest rate on the money deposited with them.
The increased interest rate has big effects. In stock market, there is less money, less to invest in stocks, hence prices of stock go down. Increase in housing loan rate will damp the realty market. A big negative effect can be that people will not borrow money to start businesses or expand existing business. We don't want that to happen either. That is why central banks increases interest in small increments, to make sure you don't feel the jolt.
posted by asterix at 5:55 PM
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