Question

Interest rates have been known to fluctuate widely over the years throughout history. Discuss why it would be a better idea for the government to slowly raise interest rates instead of reacting to catastrophic worldwide events.

Answer 1

Impact of Interest rate changes

Interest rate changes spill over to many facets of the economy, including mortgage rates and home sales, consumer credit and consumption, and stock market movements.

When interest rates increase too quickly, it can cause a chain reaction that affects the domestic economy as well as the global economy. It can create a recession in some cases. If interest rates go too high or are pushed higher than what people and companies can readily afford, spending could stop. Similarly Lower interest rates directly impact the bond market, as yields on everything from U.S. Treasuries to corporate bonds tend to fall, making them less attractive to new investors. Bond prices move inversely to interest rates, so as interest rates fall, the price of bonds rise. Likewise, an increase in interest rates sends the price of bonds lower, negatively impacting fixed-income investors. As rates rise, people are also less likely to borrow or re-finance existing debts, since it is more expensive to do so.

Role of Central Bank

Adjusting interest rates is one way that a central bank can encourage employment and keep prices stable in an economy. Central banks cut interest rates when the economy slows down in order to re-invigorate economic activity and growth. The goal is to reduce the cost of borrowing so that people and companies are more willing to invest and spend.

It all comes down to timing. The economy has to be robust enough to handle the increase in the cost of borrowing. If the Central Bank increases interest rates too quickly, before the economy is ready for it, the realized effect of the interest rate increase can be too much, and the measure could backfire. The economy would become strained and fall into a recession.

Conclusion

Due to the above reasons, Central bank should slowly increase or decrease the interest rates, since it's effects are not felt immediately and it takes time to reflect the change in the interest rates. Hence, to avoid any catastrophic effects of changes in the interest rates, like hyperinflation, devaluation, or flight to safety, central bank should not change the interest rates drastically.