There are various factors that affect the level of interest rates in an economy. They include the state of the economy, inflation levels, government spending and money supply in the economy to name just but a few. When the economy is experiencing growth it means there is a heightened economic activities in the economy. This economic boom attracts more and more investors in the economy investing. This leads to an increased demand for funds in the loanable funds market which leads to higher interest rates demanded by lenders to increase the money supply. However, the relationship between interest rates and economic growth is a two-way street as each can affect the other’s direction.
Inflation eats into earnings as it lowers the real value of earnings. With rising inflation lenders are forced to raise interest rates to keep up with the rising inflation (Schneider, 2017). This is because every rise in the inflation level translates into a loss in value in the sense that with inflation the amount of goods one could have purchased with say $500 is reduced. In the money market higher inflation tends to lower the real interest rate they thus need to revise the rates to maintain their profitability.
The government through the Federal Reserve can also influence the level of interest rates through manipulation of the money supply. The Federal Reserve manipulates the money market in an effort to regulate economic growth in the country, consequently regulating unemployment and inflation in the state. When inflation is growing rapidly and with negative effects on the economy, the Federal Reserve in order to reduce the money supply in the economy raises the rate at which they lend out money (Koziol, 2012). This in turn leads to higher rates charged by borrowers from the Federal Reserve to the households and businesses. This higher interest rate deters more borrowing thus reduced money supply.
In this case however, economic growth being stagnant, inflation being expected to remain constant, the level of saving not changing and the Federal Reserve not expected to change the existing supply of loanable funds they are thus non factors. Therefore we shall stress on reduced government spending and the effect of a foreign interest rate change in determining the level of interest rates in the US economy.
Demand for Loanable Funds
Lower interest rates encourage consumers to borrow more to finance their purchase of durable commodities such as televisions. Lower interest rates also entice firms to acquire and hold more capital. This is because the capital is now acquired cheaply and the projected income from that acquisition remains unchanged thus a higher NPV as compared to if the acquisition is made at a higher interest rate. Therefore, the lower the interest rates, the greater the demand for loanable funds. The reverse is also true. As a result, the demand for loanable funds curve is downward sloping as illustrated below.
On the Supply Side of Loanable Funds.
The main tool used by the Federal Reserve to manipulate interest rate is through the setting of the target federal funds rate. Banks are required to keep a certain amount of capital and deposit with the Federal Reserve Bank known as federal funds. The federal funds vary depending on the banks outstanding loans and deposit.it is acceptable for banks with excess reserves to loan those that run short. The rate at which these loans are made out depends on the current target federal funds rate. This funds rate forms the base upon which interest rates are determined as it is passed through to businesses and consumer loans. (Americanexpress.com, 2018)
Higher interest rates act as an incentive to consumers to forego some of their consumption in order to save more (due to the higher returns earned on their saving). Companies in turn prefer not to invest in capital goods as the higher rates work against them to lower the NVP on their capital projects. Instead they hold on to cash in the form of deposits in their banks (the banks use these deposits to advance loans to their clients) which increases the amount of loanable funds in the loanable funds market and vice versa. The supply of loanable funds is thus upward sloping.
The interaction of demand and supply of loanable funds in the market lead to an equilibrium point where the supply and demand of loanable funds is equal.
At point e supply of loanable funds = demand of loanable funds.
Government Budget Deficit
A government budget deficit refers to the case where the government expenditure exceeds its income (Aiyagari, Christiano and Martin, 1990). This is as a result of the government increasing its spending above the amount they collect from tax revenue. To finance the budget deficit the government is forced to borrow from the private sector. This raises the interest rates as the demand for loanable funds rises. Higher budget deficits may result to crowding out as less funds are available to the private sector (Magill, 1997). A cut in government spending lowers the budget deficit (with lower spending, the government can use its revenues (tax) to finance operations and if they must borrow the borrowing is significantly lower). As a result, there will be an increase in the amount of loanable funds available, as the government borrows less from the people and businesses. This causes a shift in the supply of loanable funds curve to the right. (From slf0 to slf1)
This shifts creates a new equilibrium point ei at a lower interest rate li and a higher amount of loanable funds qi. This leads to increased investments in the private sector (as the crowding out is eliminated) and consequently greater growth.
A cut in government spending will lower the budget deficit as a result lead to lower interest rates (Kühn, Muysken and Veen, 2010).
Justification
The main tool used by the Federal Reserve to manipulate interest rate is through the setting of the target federal funds rate. Banks are required to keep a certain amount of capital and deposit with the Federal Reserve Bank known as federal funds. The federal funds vary depending on the banks outstanding loans and deposit.it is acceptable for banks with excess reserves to loan those that run short. The rate at which these loans are made out depends on the current target federal funds rate. This funds rate forms the base upon which interest rates are determined as it is passed through to businesses and consumer loans. (Americanexpress.com, 2018)
A floating rate loan is also called a variable rate loan. For this type of loan, the interest rate charged on the outstanding loan balance varies in line with the prevailing market interest rates (Binder, 2017). This means that the interest payment will change depending on the economic times (prevailing interest rates). Should the prevailing interest rates rise one is then required to pay a higher interest than he/she did before. If at the time of repayment, the market interest rate has fallen, one subsequently pays lower interest than before.
A fixed interest loan is one whose interest rate charged on the loan remains fixed for the entire duration of the loan (The Guardian, 2018). The interest rate on the loan is pegged to the prevailing interest rate at the time of entering into the loan contract. No matter the direction the market interest rates take the loan interest rate remains unfazed. This is a two sided coin. On the brighter side, the policy holder is protected from market fluctuations such that should the market rates rise he/ she pays interest on the lower rate agreed upon. However, the policy holder ends up paying a higher interest than he/she would have had they partaken in the flexible interest loan should the market rates fall.
Recommendation and Justification
In the end there is no clear cut good option between these two; in the end it all depends on the expected market interest rates trend. As illustrated in part (a) above, the United States interest rates are projected to fall owing to the reduced government spending. In light of this I would advise my company to consider taking the 8% floating rate loan in order to be able to take advantage of the expected lower interest rates in this economic period if the loan is payable in the short run. However, the 8% fixed interest rate loan is desirable for long term loans to minimize variation risks.
Relationship between UK and US
The UK and the US are strong trade partners. This can be attributed to the fact that they share common values as well as a common heritage (the US was once colonized by the Brits). The UK is the United States’ fifth largest export market and the seventh largest source of imports for the US. The US exports to the UK include machinery, vehicles, precious stones and metals, electrical equipment, minerals, pharmaceuticals, agricultural, fish and forestry output, alcoholic beverages, branded snack foods, and grocery goods. The UK’s exports to US include cars, packaged medications, nucleic acids and refined petroleum. The United States’ balance of trade has ranged between a low of (-5380 in 2013) and a high of (4770.6) in 2011. The current sterling pound to US dollar exchange rate is1.34072. Foreign direct investment between the two countries is high. The US FDI in the UK concentrate on non-bank holding companies, finance and insurance and the manufacturing sectors. On the other hand, the UK FDI in the US is mostly in manufacturing, finance and insurance, banking, wholesale trade and the information.
A Raise in the Level of Interest Rates by the UK in UK
Higher interest rates are an incentive for consumers to save. This is because saving is more profitable. Consumers consequently reduce their consumption now to increase their savings. Businesses and companies now facing higher interest rates opt to hold on to their resources rather than invest in the capital projects. This is due to the fact that in investing in capital projects now only serves to lower their earnings on the projects as their net present value is significantly lowered. There is therefore an increased supply of loanable funds in the loanable funds market. This higher supply of loanable funds in the market shifts the loanable funds supply curve to the right as illustrated in the figure above. The interaction of demand and supply of loanable funds in the market results in a movement in the demand for loanable funds curve to a higher quantity demand q1 and a lower interest rate i.e.
The higher interest rates also have an impact on the exchange of the sterling pound to the other currencies. The higher interest rates increase the value of the UKs pound against the currencies of other countries say US as in this case (Hnatkovska, Lahiri and Gramont, 2008). This tends to make imports cheaper this is because for 1 GBP consumers can buy or pay for more goods than before (you pay less than before with appreciation). Exports on the other hand become more expensive than before in the sense that for every 1 GBP of goods and services exported exporters get a lower return than before (Yung, 2014). This therefore increases the quantity of imports vis-à-vis exports which translates into a trade deficit.
The higher interest rates also have an influence on foreign direct investment. FDI refers to the investments made in a country not by its citizens by foreign nationals and companies. Higher interest rates in the UK as compared to the US make investment in the UK more attractive. As a result there will be increased investment in the UK by foreign companies and business resulting in what is commonly referred to as “hot money flows”. This is because investors are always after highest yields with lowest risks possible. This is only too true especially with UK’s established ease of doing business.
Effect of Higher Interest Rates in the UK on the US
The higher interest rates in the UK as compared to the US makes saving in the UK more attractive to the American households than in the US (Carriero, 2006). This is due to the fact that this will yield greater interest earnings on their savings. This is also true with businesses and company’s .this greatly affects the money supply in the US economy resulting in lower supply of funds in the loanable funds market in the US following the out flux. (The fact that the Federal Reserve is not expected to affect the existing supply of loanable funds over the next year means that any changes in the level of interest rates and loanable funds is left to the market mechanisms of demand and supply to mitigate this problem).
With increased savings in the UK it means that consumption in the US is subsequently lowered as households are keener on earning the higher interests. The subsequent lower money supply means that there are fewer dollars chasing goods and services (the dollar now has a stronger purchasing power). The lower demand forces suppliers of goods and services to lower their prices in order to boost its demand. Following the law of demand where prices and demand are inversely related then this would lead to increased demand for goods and services. To meet this growing demand households will need more funds thus an increased demand for money in the economy. This will shift the demand curve of loanable funds to the right from DLF0 to DLFi shifting the equilibrium point from e0 to ei. This will cause a movement along the supply curve SLF. At the original equilibrium point e0 the equilibrium interest rate and quantity of loanable funds is i0 and q0 respectively. After the shift the new equilibrium point is ei with equilibrium interest rate and quantity being ii and qi respectively.
The interest rate following the shift is higher and so is the quantity of loanable funds. Therefore, an increase in the interest rate of the UK will lead to a rise in the interest rate of the US as well.
Aiyagari, S., Christiano, L. and Martin, S. (1990). The output, employment, and interest rate effects of government consumption. Minneapolis, Minn: Institute for Empirical Macroeconomics, Federal Reserve Bank of Minneapolis.
Americanexpress.com. (2018). American Express UK | Log in | Credit Cards, Travel & Rewards. [Online] Available at: https://www.americanexpress.com/ [Accessed 22 May 2018].
Binder, C. (2017). Interest Rate Prominence in Consumer Decision-Making. Economic Inquiry, 56(2), pp.875-894.
Carriero, A. (2006). Explaining US-UK Interest Rate Differentials: A Reassessment of the Uncovered Interest Rate Parity in a Bayesian Framework*. Oxford Bulletin of Economics and Statistics, 68, pp.879-899.
Hnatkovska, V., Lahiri, A. and Gramont, C. (2008). Interest rates and the exchange rate. Cambridge, Mass.: National Bureau of Economic Research.
Koziol, P. (2012). Enhancing FX Risk Management with Inflation and Interest Rate Derivatives. SSRN Electronic Journal.
Kühn, S., Muysken, J. and Veen, T. (2010). The Adverse Effect of Government Spending On Private Consumption in New Keynesian Models. Metroeconomica, 61(4), pp.621-639.
Magill, F. (1997). International encyclopedia of economics. London: Fitzroy Dearborn.
Schneider, H. (2017). Is the Fed ready to consider lifting its inflation target? [Online] U.S. Available at: https://www.reuters.com/article/us-usa-fed-inflation-analysis-idUSKBN19630N [Accessed 20 May 2018].
The Guardian. (2018). Interest rates [Online] Available at: https://www.theguardian.com/business/interest-rates [Accessed 22 May 2018].
Yung, J. (2014). Can Interest Rate Factors Explain Exchange Rate Fluctuations? SSRN Electronic Journal
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