Question

What implications do interest rate levels have on the economy?

Answer 1

• Interest - the cost of borrowing
• Interest rate- the rate expressed as a percentage of the total sum borrowed for a stated period of time
• Regulated by Central bank during the early stage of financial market development (1955 to 1965)
• But, the country's central bank namely Nepal Rastra Bank gradually began to liberalize
• In early mid 1980's economic policy liberalized CB guides BFIs
• Basically determined by demand and supply of funds

Structure and its level depends on

• the behavior of the yield curve
• composition of the maturity structure
• sensitivity of the change in the interest rate, and, default risk included in matching the level of interest rate and its relationship with the yield curve

Interest rate changes affect the whole economy

• Exports and imports
• Balance of payments
• Exchange rate
• Housing market
• Unemployment
• Economic growth
• Demand for loans
• Consumer confidence
• Demand for goods
• Inflation

Implications

Business and interest rate

• Effect of a change in interest rates on business depends on:

The amount that a business has borrowed and on what terms

The cash balances that business holds

Whether the business operates in markets that depend on consumer spending

The effect on consumer demand

• The demand for goods and services is likely to fall as a result of a rise in interest rates:

Consumers might choose to save rather than spend

They will be less willing to make credit purchases

Mortage holders suffer a fall in discretionary income following the rise in monthly mortage payments

• But a rise in interest rates will not impact equally on all parts of the economy
• it will impact disproportionately on demand for luxury goods and on demand for goods purchased on credit

The effect on business investment

• Rise in the cost of borrowing will reduce the profitability of a proposed investment
• Investment will be less attractive because:

It will cost more to borrow money

Customer demand will be lower

The expected return on investment will be lower

The payback period will be longer

Interest rates & exchange rates

• High interest rates in the UK (compared with other countries) will cause an inflow of capital into the UK
• This increases the demand for sterling and reduce the supply
• As a result the exchange rates goes up
• A stronger currecncy will make exports more expensive ( thus reducing volume) and impots cheaper (thus increasing volume)

If an interest rate rise a problem

• Price discounts to stimulate demand
• cost cutting to maintain margins and conserve cash
• reduce capacity - eg. short time work, redundancies
• Improve management of working capital- eg. destocking
• reduce the debt burden
• cut back on investment plans