Question

In: Economics

a) What three factors have been suggested for the decline in real interest rates in the...

a) What three factors have been suggested for the decline in real interest rates in the world?

Solutions

Expert Solution

Dear Student,

Below are the factors that cause to decline real interest rates in the world

1) Demand for money

Typically, in a growing economy, money is in demand. Manufacturing sector companies and industries need to borrow money for their short-term and long-term needs to invest in production activities. Citizens need money as they need to borrow for their homes, buy new cars, and other needs. But when an economy isn’t doing that well, companies avoid borrowing if the demand for their products is low.

A very high inventory is detrimental, so they produce less. In effect, they borrow less, ergo less demand for money. Consumers also spend less as a bad economy could result in job loss. Other things remaining the same, higher the demand for money higher the interest rates.

2) Supply of money:

Like any other commodity, if the supply of money increases, other things remaining the same the price of money—interest rates, go down.

There are situations wherein the investors do not have attractive avenues and they chase the bonds or deposits. If there is no demand for that money at that moment, then the interest rates go down.

3) Fiscal deficit and government borrowing

Fiscal deficit is a result of government expenditure exceeding government revenue. To fund this deficit, the government resorts to borrowing. Being the largest borrower in the economy, the quantum of government borrowing influences the demand for money and in turn sways interest rates.

Higher the fiscal deficit, higher the government borrowing, higher the interest rates. Generally, bond markets respond to higher fiscal deficits by an uptick in bond yields.

4) Inflation

Prices of all goods and commodities are set by taking into account the general price increase in the economy—inflation. Interest rates, which the price of money, are no exception to this rule.

Savers need to be compensated by way of higher interest rates for sacrificing their current consumption motives in a high inflationary scenario. Investors will forgo their current consumption and invest in fixed income investments if they get positive real rate of return.

The real rate of return is arrived at by deducting inflation number from the nominal rate of return offered on the bonds and deposits. The ideas to keep the real rate of return positive so that after inflation the saver saves something. That means in high inflation era, the interest rates tend to stay up and vice versa.

5) Global interest rates and foreign exchange rates

Attractive interest rates bring in capital and support the foreign exchange rate. Tweaks in the interest rates in the economy can be used by a central bank for influencing the exchange rate. A central bank may choose to up the policy rates (repo rate in India) to indicate higher interest rates in the economy and thereby attract capital from overseas investors.That means the interest rates in the economy must be set in line with global trends in interest rates.

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