Composition of Interest Rates

The Federal Reserve is the single entity in control of the monetary policy of the United State of America. Monetary policy is the process that the Federal Reserve takes in order to control the supply of money and to attempt the control the direction of interest rates. The reason for doing these actions is in attempt to control the country’s inflation and employment rates, which are the biggest indicators and factors of a healthy economy.

16. If the nominal interest rate on an account is 1% and the inflation rate is 2%, the real interest rate is:

By law, the Federal Reserve conducts monetary policy to achieve its macroeconomic objectives of stable prices and maximum employment. The Federal Open Market Committee usually conducts policy by adjusting the level of short-term interest rates in response to changes in the outlook of the economy. Since 2008, the FOMC has also used large-scale purchases of Treasury securities and securities that were guaranteed or issued by federal agencies as a policy tool in an effort to lower longer-term interest rates and thereby improve financial conditions and so support the economic recovery (What).

Time preferences are based on their time for consumption and solely by personal preferences. This is dependent on the needs of the investor. The basis of this is if the investor wishes to save his money for the future, that investor may accept a lower return for future consumption. An investor who has the need for high consumption (needs money in the short term), will lend the money only if the interest rate is high. The needs of the investor will play into the ability for a business to borrow money. If investors need long term, future returns, then interest rates would lower, if the investor needs money in the short term the interest paid to attract the investor and their capital will need to be higher.

The definition of consumer expenditure is the amount of money spent by households in an economy. The definition of investment is the spending by firms on capital good such as new machines etc. Finally the definition of interest rates is the proportion of a loan that is charged as interest to the borrower, normally expressed as an annual percentage. In the UK the interest rates are set by the Monetary Policy Committee and are usually used in order to influence levels of aggregate demand.

According to the Federal Reserve Bank of San Francisco (2002), inflation can be defined as the increase in the level of prices and a decrease in the purchasing power of money. In short, money loses its value due to the increase of the prices of goods and services. Products that can experience this are food, clothing, electronics, raw materials, and more. The reasons for these occurrences are complex since there are two types of inflation, and each has its respective causes.

Janet Yellen states, “the possibility that low long-term interest rates are a signal that the economy's long-run growth prospects are dim….depressed long-term growth prospects put sustained downward pressure on interest rates. To the extent that low long-term interest rates tell us that the outlook for economic growth is poor, all of us should be very concerned, for--as we all know--economic growth lies at the heart of our nation's, and the world's, future prosperity.” A high interest rate is usually set when an economy is already well off. An example of an economy that's well off is with the result of inflation. But if inflation is left unchecked it will lead to a loss of purchasing power meaning that your dollar is worth less than what it was before. This is where high interest rates become a great convenience to the economy. Though this may sound proficient, ultimately a high interest rate that lasts lead to struggles within the economy. Borrowing will become more difficult due to rates being to high which will also cause less productivity to

The interest-rate effect explains that when the price level decreases, consumers have more money left over after consumption (because prices have dropped) which they can then place in financial intermediaries (banks) who can in turn loan those funds out. An increase in the supply of

Monetary policy uses changes in the quantity of money to alter interest rates, which in turn affect the level of overall spending . “The object of monetary policy is to influence the nation’s economic performance, as measured by inflation”, the employment rate and the gross domestic product, an aggregate measure of economic output. Monetary policy is controlled by

Monetary Policy, in the United States, is the process by which the Federal Reserve controls the money supply to promote economic growth and stability. It is based on the relationship between interest rates of the economy and the total supply of money. The Federal Reserve uses a variety of monetary policy tools to control one or both of these.

      Monetary policy is under the control of the Federal Reserve System and is completely discretionary. It is the changes in interest rates and money supply to expand or contract aggregate demand. In a recession, the Fed will lower interest rates and increase the money supply. The Federal Reserve System’s control over the money supply is the key Mechanism of monetary policy. They use 3 monetary policy tools- Reserve Requirements, Discount Rates/Interest Rates, and Open Market Operations. The reserve requirement is the percentage of bank deposits a bank must hold in reserves and cannot loan out. By raising or lowering the reserve requirements, the Fed controls the amount of loanable funds. The interest rate is the amount the FED charges private banks, so they can meet the reserve requirements. The prime rate is currently set at 5%. If the Interest rate is low, the banks will borrow more money from the FED and the money supply will increase. Interest rates have been above average for the past 20 years, but are currently considered low. Open Market Operations is the most effective and most used

Low interest rates will also alter the behaviour of consumers, businesses and banks. One of which is excessive risk taking as credit is more accessible. Especially after the financial crisis when the economy is in recovery mode, individuals and institutions might take unnecessary gambles in order to recoup what they have lost. This will lead to a high credit bubble where people are unable to repay their loans. However, people might react differently. They might be more prudent with their money thus reducing the demand, which will lead to an economic decline. As human behaviour is not possible to quantify and predict accurately, this presents the government with a dilemma,

When dealing with interest rates and inflation the standard equation that is used is Fisher equation. What the fisher equation explains is that the real interest rate and expected inflation equals to the nominal interest rate (it = rt + Etπt+1) This means that a rise in expected inflation causes lenders to raise their nominal interest rates as there would be a decrease in the value of their loans due to purchasing power of repayments being lower and this causes the decline in investment as borrowing costs rise.

This is the situation where the commercial banks and other lending institutions borrow from the central bank at lower interest rates compared to how they will lend. This gives the institution a chance to vary credit conditions depending on the central bank lending rates. If the central bank raises its lending rates, then the other lending institutions will have to raise their rates too, thus discouraging the public from borrowing. But if the central bank lowers its rate, then commercial banks and other institutions will be forced to lower their rates too. This will encourage the

     Most People have money in a savings account and wonder how to figure out the actual interest rates or the APR (annual percentage yield). To find the amount of interest you would use this formula: P (principle) x R (rate) x T (time) = I (interest)