Question

Assignment : Imagine that a friend who knows you are working toward your degree in business administration is complaining about interest rates. Perhaps they think the rate they are getting on savings vehicles, like money markets, is too low, or the interest they are paying on their mortgage is too high. They conclude that it seems like no matter what they lose. 1) Respond to your friend's concerns. Be sure to be specific in supporting the points you are making and referencing your readings.

Answer 1

The concerns on interest rates seem legit to a person who does not have intricate knowledge of how exactly the whole financial system works.  Let us see the big picture first , interest is a amount paid on a principal amount at a specific rate, that rate is called interest rate. The interest is basically a cost which the borrower has to pay if in case the borrower defaults on the payment.

If we get into the details there are other factors as well, the amount that is being borrowed by a bank or government itself that is in money market the risk is next to none, hence the interest rates for such amounts are so low. Now, if a bank provides a mortgage and the person has to pay a certain amount of interest on it, it would be higher as the borrower is a person and the amount of risks involved in defaulting on the payments is way higher if compared to a bank or a government backed bond. And so the whole system works on this credit risk majorly.

There are other elements into it as well, the inflation is second most concerning of them all. The inflation is the eventual loss of a dollar value over a commodity. Let us consider an example if a pack of bread costs a dollar or two today, but if we compare it to say 1950's the cost would be around eighteen cents which is much lower comparatively, this is due to inflation the value what we pay today will be worth lesser in the future, hence the bonds with a longer time period tends to have higher interest rates as the value decreases.

To consider another factor here are federal funds rate, the fed is the bank of the banks. The fed bank decides the lending and borrowing rates between the banks (inter-bank) , if the banks deal with each other or with the federal bank itself at a certain rate than why should we be concerned, how these rates affects us is the questions of many, well to put it simply, the rates are conveyed to the costumers. Whenever the changes are being introduced in the fed rates, the fed decides that the banks should let the borrower borrow money at a higher or lower interest rates to maintain the flow of money and the inflation as well.

The major reasons here for higher interest rates that a person has to pay are credit risk, inflation and fed rates. And the very same concept can be applied in a vice versa manner when it comes to low interest rates in money market instruments. If there is high interest rate there will be higher risk associated with the instrument.