Economy and Business>>The Interest Rate
The bank interest rates are the price of money and a tool of the monetary policy uses the federal reserve in the US and other institutions in their respective countries to stimulate or constraint the economy.
The bank interest rate is originally given by the inflation rate, and the fact that people prefers money today than in the future. If I lend $500 to my friend and after a year, he gives it back to me the same amount, I will have lost money because of the inflation rate, $500 of the year n+1 are less money than the year n (unless there was deflation). At the same time, people uses to prefer $490 now, than wait one year to have $500.
It can be also used as a tool of the monetary policy. A high rate will cause people to hold more money in the bank and find all the projects less rentable, and then decrease the liquidity in the economy. On the other hand, a low rate, will encourage people to withdraw money from the bank and invest it in projects, increasing the liquidity.
If I have the opportunity to invest in a project with a 6% of profit after a year, and the interest rate is 5%,I will prefer to have my money safe in the bank, than risk it for just an extra 1% . But if the fed rate is set to 2%, I will see that project more attractive, as it gives me three times more rentability than holding my money in the bank.
Mechanism to force the bank Interest Rates
In Democratic countries, are central banks who force a desired interest rate with open market operations. Nobody can say: today the banks will lend money at thefederal interest rate. First of all, interest rates use to be an average of what banks charge to borrow money between themselves. This changes among countries giving a lot of different rates. The mechanism of all them uses to be very similar but with different names and calculated using data from their respective countries. These two are good examples:
Building of the Federal Reserve Bank of New York
Note that both the Fed and the ECB use Open Market Operations to force a targeted rate but the ECB uses to sell liquidity to the banks in an auction where the minimum price is the Euribor , and the Fed uses to buy or sell national securities. Buying national securities increases the liquidity of the market and with this, causes the interest rate to decrease, and selling them makes the reverse effect.
The Interest Rate in The Monetary Policy
The central banks can control the monetary policy in three ways: i) Supply of money ii) availability of money and iii) cost of money or raw interest. So by iii the ECB can increase or decrease the Euribor according on the needs of the economy, and the same happens with the FED. there are two kinds of policies:
The Image above represents the economic cycles according to the growth of the GDP
The choice of a policy or another depends on the cycle of the economy, There are many examples of why interest rate must be set correctly. For example, in the European union there is a unique interest rate, but all the countries are different and while some are growing, others have an sluggish growth. While the ECB lowered the bank interest rates to stimulate the German Economy, Mediterranean countries like Spain Greece or Italy began a speculative housing development feed by the abundance of liquidity caused by a too low Interest rate for their economic growth. This situation drove to a stronger recession in these countries when banks suddenly decided to not give more mortgages at all, and everybody realized that the Spanish economy (46 millions of inhabitants) built in 2008 nearly as much housing as the whole United States.
Fiscal policy can also be used to obtain the same effects as changing the interest rate. Increase taxes will lower the liquidity but is an unpopular measure. On the other hand lower taxes (without lowering public expenditure) increase the liquidity but may cause deficit. Since Fed funds rate was set to 0% in December of 2008, the fed spent all their ammunition to boost the economy, but the administration Obama kept boosting with a fiscal stimulus, this also boosted the national debt but the economy reacted positively.
