Question

In: Economics

Identify the other macroeconomic factors that affect the general level of interest rates and discuss how...

Identify the other macroeconomic factors that affect the general level of interest rates and discuss how each of these factors affects interest rates

Solutions

Expert Solution

Macroeconomic factors that affect the general level of interest rates are -

International borrowings
With the increasing globalization over last few years, the economic conditions of international markets have also started playing an important role in deciding the interest rate direction. The global economic conditions influence the lending pattern of foreign investors to domestic companies, and thus compete with domestic sources of funds in the market.


Fiscal deficit and government borrowings
The government policies and their impact on the fiscal deficit is another factor that influences the interest rates indirectly. The government borrows money from the market to fund its fiscal deficit. A rising fiscal deficit (as percentage of the GDP) indicates that the government will have to borrow more from the market. This puts an indirect upward pressure on the borrowing rates in the market.


Inflation
The rate of inflation is another important factor that governs interest rates on loans. The lenders prefer lending at interest rates that are higher than the rate of inflation. Otherwise, they will post a negative growth in absolute terms. Therefore, a rise in the rate of inflation signals a higher interest rate regime. On the other hand, a drop in the rate of inflation indicates a softer interest rate regime.

RBI moves
The RBI governs the monetary policy. It controls the monetary activities such as money supply, liquidity, and interest rates through its key policy rates - repo rate and reverse repo rate, and ratios - cash reserve ratio (CRR) and statutory liquidity ratio (SLR). The RBI's key policy rates act as a benchmark for the interest rates. Similarly, the policy ratios act as controls for the liquidity in the system. The RBI keeps tuning these para ..


Supply and demand:

When you think of interest rates as a price for borrowing money, it makes sense that they would be affected by supply and demand. In lending, an increase in the demand for money, or a decrease in the supply of money held by lenders, will cause interest rates to go up. For example, if a lot of people started pulling all of their money out of their checking and savings accounts, that would decrease the supply of money that banks have to lend to borrowers, which would likely raise interest rates at those banks. Conversely, a decrease in the demand for money, or an increase in the supply of money, will lower interest rates as lenders try to attract more borrowers

Federal funds rate: The interest rate that financial institutions charge one another for short-term loans is called the federal funds rate. It’s determined by the U.S. Federal Reserve, which uses the federal funds rate as a lever to help balance the economy. When the economy is slow, the Federal Reserve can lower the federal funds rate to encourage more borrowing, and when the economy is growing too fast, which can trigger large increases in inflation, the Federal Reserve can raise the federal funds rate to discourage borrowing. The interest rates that these big financial institutions charge one another creates a baseline that influences the prime rate, or the interest rate that banks charge to their best customers who have the lowest possible risk of defaulting on their loans, which in turn affects the interest rates for everyone else. So, when the federal funds rate goes up, as it recently did, interest rates go up along with it.


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