Economics: Importance Of Controlling Interest Rates (Term Paper Sample)

Interest Rates
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Abstract
This paper examines the relationship of interest rate with other macroeconomic components of an economy. A detailed comprehensive explanation of how interest rate level can be regulated or controlled is given as well as the importance of the control. Canada and the United States economies are analyzed with regard to their interest rate policies. The analysis proves that change in interest rate level in the United States have either positive or negative impact on the economy of Canada. IS-LM model is applied in the explanation of shifts in interest rates and their effects on either product markets or money markets. Interest rate is one of the instruments employed by policymakers in designing development and growth plans because it affects investment and level of money supply directly. It is proven in the discussion that interest rate affect trading terms and growth patterns and hence a concern to policymakers.
Table of Contents
Introduction…………………………………………………………………………………..4
Importance of controlling interest rates ………………………………………………………4
Analysis of Interest Rates in Canada and United States ……………………………………..5
Role of interest rates in policy-making ………………………………………………………13
Conclusion ………………………………………………………………………………..….15
References ……………………………………………………………………………………16
Introduction
The term interest rate refers to the extra amount loan borrowers are required to pay back to the lender on top of the total amount borrowed. From the perspective of economics, interests can be interpreted as the compensation received as a result deferring consumption. Interest rates are a very important aspect of the economy as they affect other macroeconomic components such as investment level, employment rate, inflation rate or the price level and rate of economic growth. Since the level of interest dictates many aspects of the economy, governments generally put in place policy measures to regulate its level. The main measures applied in this case are the fiscal and the monetary measures or tools. Control of interest rates is a complex task in the sense that neither high-interest rates nor low-interest rates are absolutely beneficial to the economy but the optimum level depends on the state of the economy. World economic giants like the United States are considered to have adopted effective policy tools of managing interest rates thus achieving economic stability. This paper examines the role of interest rates in striking balance between product (IS) and money markets (LM) in the context of Canada and the United States.[Friedman, Benjamin M. The role of interest rates in Federal Reserve policymaking. No. w8047. National Bureau of Economic Research, 2000.]
Importance of controlling interest rates
Interest rates are controlled with an intention of fostering price stability and maximum employment rate. Monetary control is usually done by the central bank through manipulating discounting rates, open market operations, and reserve requirement. By buying or selling securities in open markets the central bank is able to control interest rates and consequently money supply. Alternatively, the central government can either raise or lower bank reserve requirement which is simply the amount of money commercial banks are strictly required to hold. This influences the amount of money available to the bank for loaning purposes and hence interest rates. When there is need to expand market activities such as investment, the central bank lowers interest rate by buying securities, lowering interest rates and lowering the commercial bank's reserve ratio to encourage borrowing and investment. On the other hand, if the central bank is concerned with suppressing market activities especially during economic boom then it can increase reserve ratio, increase discounting rates and sell securities to the public. All these are effective monetary policy measures.
Interest can rate affect demand and supply due to the fact that interest rates directly influence money supply which in turn determines the ability to purchase. When interest rates are low, people are motivated to borrow from banks since they would not be charged a lot in the event of repaying money. At the same time, individuals are discouraged from saving in banks since the money will earn insignificant amount inform of saving interest. These increase amount of money circulating in the economy and thus more transactions. However, high-interest rates increase people's incentive of putting money in banks so that it can accumulate interest rates. Also, potential investors would be discouraged from taking loans due to the high amount charged interest. A decreased demand for goods and services eventually leads to low supply since the market forces operate to attain a new equilibrium.[Friedman, Benjamin M. The role of interest rates in Federal Reserve policymaking. No. w8047. National Bureau of Economic Research, 2000.]
Analysis of Interest Rates in Canada and United States
To analyze interest rates between the United States and Canada, the differences in their mortgages and Federal Reserve can be examined. The two economies are said to be closely related and phenomenal market events and activities in either of the two economies affect the other. For example, a hike in Federal Reserve rate in the United States has been proved to affect earning of the Canadians. The recent increase I n interest rates in the U.S is an implication that the Central Bank is confident that the United States economy is growing. On the other hand, the interest rates of Canada have remained unchanged for the last two and half years. , The widening gap between the Canadian and United States' interest rates usually results in the weaker loonie. There are differences between the United States banking systems and consequently their mortgage systems. One of the differences emerges from the fact that in the United States the number of domestic banks is extremely higher as compared to those of Canada. The USA has more than seven thousand domestic banks which are characterized by intense competition while the Canadian banks are only twenty-eight. This intense competition in the United States could explain the frequent changes in interest rates since banks can use interest rates to attract customers. Regulation of banks and other financial institutions differs in the two countries. U.S banking system is considered to be intuitive unlike the case of Canadian systems. The U.S banks are mainly concerned with banking access, consumer protection, anti-money laundering and privacy.[Chen, Kan, and Nathaniel Karp. "Natural Interest Rates in the US, Canada, and Mexico." (2017).]
Mortgage lending differs significantly between U.S and Canada although homeownership is almost similar. In Canada, mortgage interests are not tax deductible, the down payments are relatively larger, they involve huge pre-payment penalties and the terms do not exceed thirty years. From this perspective, it can be concluded that propositions of a speculative real estate are a less likely phenomenon in Canada. On the other hand, the United States occasionally subsidizes mortgage lending through government entities that besides providing mortgage insurance and loans, they also purchase mortgages from banks. The reselling of mortgages in the United States enhances its banks to bear the greater risk. Customer base, mindset, and regulatory measures are the key factors which induce difference between the Canadian and USA banking systems and consequently their ability to control interest rates.[Fischer, Stanley. "Why are interest rates so low? Causes and implications." Speech at the Economic Club of New York. New York. October 17 (2016).]
IS-LM model can be used to enhance better understanding of the concept of interest rates. I and S stand for Investment-Saving levels at a given interest rate at ceteris paribus. It represents the equilibrium in goods or commodity market. The IS curve shows the desired interest rates at different combinations of investment and savings. On the other hand, LM refers to the liquidity preference for money. It gives a relationship between money supply and money demand with the interest rates.
Changes in U.S interests’ rates affect its trading exchange rates with other countries. Movements in United States’ interest rates can pose monetary policy problems in other open economies like in the case of Canada. Interest rate movement in Canada is not directly related to that of the United States but in some sub-periods, the Canadian interest rates respond directly to that United States. The appropriate response exhibited by Canada as a result of United States' interest rate movement is determined by the difference between U.S real rates and nominal rates. It can also be determined by the ...