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    Interest Rate???

    Why do you think the government follows interest rate changes in financial market?
    I need a little help with the above question. I'm not sure how to answer or even what's the right answer for it... (one of the qs. in my 'personal finance math' this yr)...

    #2

    Although i am not a business student or have any knowledge regarding this topic ... I'll still add my 2cents worth and maybe someone else can correct me.

    The financial market is followed to see inflation rates and the interest rates is used to control inflation somewhat i think

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      #3
      You have to also tell us the level at which this question is asked. The answer can range from very elementary to extremely technical, depending on the level of course.

      On a simple level, the government uses interest rate as a monetary tool to control the economy and inflation.

      If interest rate is low, people will be able to borrow money (for homes, cars, etc). Consumer spending will increase, and this will result in inflationary pressure (demand increases) and prices go up. People will also be able to borrow money cheaply to invest in their businesses, or in the stock market and it will provide stimulus to the economic activity in the country. It works well in recession, when govt is trying to encourage people to spend and boost up the economy.

      On the contrary, if the govt increases interest rate, the supply of money will shrink. People will not borrow money, consumer spending will decrease (demand for goods will decrease), prices will go down, inflation will go down, people will be keeping more money invested in interest bearing instruments. It works well in economic boom, when govt wishes to control inflationary pressures.

      As an example, right now in USA, there is a downward trend in interest rates, bcz the govt is trying to boost up the economy by providing low interest cheap money to people so they can spend it or use it in their businesses.

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        #4
        D500s: Thnkx http://www3.pak.org/gupshup/smilies/smile.gif

        Pristine: Thnkx! This is exactly what i was looking for http://www3.pak.org/gupshup/smilies/smile.gif if there's anything else that you'd like to add, plz do so http://www3.pak.org/gupshup/smilies/biggrin.gif

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          #5
          Do remember that the government does not directly control the interest rate. It is the responsibility of state bank (e.g. Federal Reserve Bank in USA or State Bank of Pakistan). The government can work with the federal bank to coordinate the fiscal and moetary policies for overall economic growth of the country.

          What these state banks do is to alter the interest rate offered to the regular banks on their deposits. As a direct effect, those regular banks (e.g. Citibank, Bank of America, Wells Fargo etc) alter their own interest rates. This will impact the home loans, bank certificate of deposits and other transactions, as explained above.

          The rates of interest offered by the banks are composed of several complex factors and do not merely constitute the interest rate of the federal or state bank. So, when feds change the interest rate, the ripple effect will not be uniform all over.

          Secondly, interest rates are just one tool in a variety of tools available to the government to manage economy. They can control the supply of currency, alter tax rates and a host of other measures. Managing interest rates is almost always accompanied by other measures to have the desired effect.

          Comment


            #6
            Pristine pretty much said it. Here are some more details in case you need more.

            The government does not "control" the interest rate directly at least in the US but rather the Federal Bank controls the monetary base (or the amount of money available) in the market. Which in turn affacts the interest rate. Hence when the Feds say they have lowered the interest rate, they are not actually lowering the interest rate but changing the amount of money available to banks - and hence to the populace - that would indirectly lower the interest rate.

            Lowered interest rates imply that they the cost of capital (that is money) is cheaper and hence people and businesses are encouraged to spend money on buying things (hence the term capital investment). This in turn leads to an increase in demand of goods and services - because the money is spent on goods and services by both consumers and businesses.

            Increased demand for goods and services means that there is increased employment - hence increase in the total income - which in turn leads to more spending cause the people have more money to spend. Also increase in goods of one kind also cause a more indirect increase in goods of other kinds.

            So say $4 billion is spent by the government on boeing for airplanes. This in turn means that Boeing in turn needs the raw materials to make these planes (say that costs $2billion) so now we have an increase in income and employment at boeing as well an additional demand for $2 billion worth of raw materials, which in turn would mean increased income for some other consumers elsewhere. So in this manner, the original $4 billion actually adds a lot more just the $4 billion to the economy of the country.

            Hope that helps. Let me know if you need more info.

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