Question

Part B Interest rates have been dropping rapidly recently across the globe. Explain possible risk implications and evaluate knock on effects this may have on the local economy. (1500 words - 30 marks)

Answer 1

Changes in interest rates affects the economy in both positive and negative way. Lowering interest rates makes borrowing money cheaper. This would encourage consumer and business spending and investment. It also boost asset prices. It can also lead to problems such as inflation and liquidity traps which undermines the effectiveness of low rates. The inflation leads to reduce the purchasing power and hence undermining the sustainability of the economic expansion. Low interest rates can damage the economy and it is considered to be the predictive indicators of economic crisis. It will lead to increase rise in cost of living and asset price. They also lower the return on fixed income investments which provide income for retired individuals, foundations and other entities dependent on both interest for income. Low interest rates can cause increased risk taking to meet investment return or income targets. Banks, insurance companies, funds, charitable foundations and all have income targets. They must meet by using return on investment or loaned money. Banks can lower their lending requirements and make larger loans to borrowers with poor credit, who expect to pay considerable more than the prime rate. A normal economic contraction is the result of the Fed raising interest rates and removing money from the monetary system, so when it comes spurring growth to boost the economy out of a recession, the Fed might aim to lower interest rates a few points to encourage small business and consumer borrowing. Banks have lots of money in their deposit accounts, attracted by high interest rates, so they are eager to lend to you. However, when interest rates are abnormally low, banks don't have a high deposit base and the income from loans doesn't encourage taking risks, so they only loan to borrowers with the highest credit ratings and substantial assets to collateralize those loans. That is why it is difficult for you to finance your small business operations and you might even have to lay off some of your employees to reduce your expenses as your business slows because your customers can't borrow to buy from you. A liquidity trap happens when interest rates are so low that they don't serve the normal function of spurring the economy to growth. Instead, they reduce the flow of money to the Main Street economy because it goes into investments in assets that don't produce employment, such as the stock market and paying down loans. This means money doesn't flow through the economic system. When that happens, unemployment rises as companies lay off expensive workers and hire contractors and temporary or part-time workers at lower prices. When wages decline, people can't pay for things and prices on goods and services are forced down, leading to more unemployment and lower wages. This is the danger of deflation, which is difficult to stop as the economy spirals down. Normally, low interest rates encourage loans, and loans add new money to the money supply. After the credit crisis of 2008, for example, the Fed lowered rates and injected money into the system to try to spur economic activity. This created a large money supply and a liquidity trap. In a normal economy, too much money in the system results in inflation because it chases a fixed amount of goods and services, so prices rise. The risk of recovery from a liquidity trap is inflation if the Fed doesn't remove enough money from the system as money comes out of assets and enters circulation in the business and consumer economy. The Central Bank usually increase interest rates when inflation is predicted to rise above their inflation target. Higher interest rates tend to moderate economic growth. Higher interest rates increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending. Higher interest rates tend to reduce inflationary. The primary interest rate (base rate) is set by the Bank of England / Federal Reserve. If the Central Bank is worried that inflation is likely to increase, then they may decide to increase interest rates to reduce demand and reduce the rate of economic growth.