How interest rates affect you
too much money maybe bad for the economy
Hello and welcome to another issue of this newsletter.
Thanks to Fairy, Embashsho and Deborah for your input. Found it useful and will adjust as we move forward.
A piece of writing I did this past week is 10 Financial Tips.
Now let’s get into today’s piece: Interest rates.
Interest rates Inflation
Inflation is the rate of increase in prices of commodities and services. A lot of things cause inflation. But these things are mainly classified as either demand-pull or cost-push.
Demand-pull inflation is when the prices of goods rise because there is a shortage of supply. Therefore, the supply of commodities can’t meet the demand. That is, a lot of money chasing few goods. (remember this)
Zooming in, one of the reasons there is a lot of money chasing a few goods is because there is a high supply of money in the economy. This is a result of interest rates.
Interest rates
Controlling interest rates is one of the tools The Fed central banks use in controlling the quantity of money in the economy, aka monetary policy.
The interest rate is the cost of borrowing money from a lender. This is the money you pay extra for borrowing money. For example, I borrow $100 from a credit facility and am charged 1%. That means I pay an additional $1 for every $100 I borrow. If this cost increases, then it becomes more challenging to pay back and more challenging to borrow money. Therefore, when the interest rates rise, the cost of borrowing increases and therefore, people are somewhat discouraged from borrowing.
What does this have to do with the economy, inflation and the central bank?
The central bank sets the baseline of the interest rate. All other lending institutions take a hint from the central bank’s interest rate. Say, for example, the central bank charges banks 1.75% interest. The banks then charge their customers 1.75%+ whatever the bank wants to charge the lender based on their credit worthiness.
When the central bank increases the rate to 2%, lenders begin to charge 2%+,, and if the rate is reduced to 1%, the lenders also reduce theirs to 1%+.
To the economy, when the interest rates are low, it means it costs less to borrow money. Therefore, more people and businesses borrow. This means there is a lot of money in the economy. If this supply is not matched with productivity, then there will be problems. What does this mean?
When the supply of money in the economy increases, there is usually an expected increase in the production of goods and services(i.e. supply of goods and services is also increasing). This is what I refer to as productivity. When this doesn’t happen, then there will be a lot of money chasing a few goods and services, which is the definition of demand-pull inflation.
There are other causes of demand-pull inflation, such as a breakdown in the supply chain, and infrastructure deficit which makes it hard for goods to get to their customers/warehouses or stores.
A vivid example is during the COVID-19 lockdown; the US government gave out stimulus cash to individuals and businesses. This meant that everyone was flush with money. However, there was little productivity since most businesses were shut down except for “essential businesses”. This is one of the numerous reasons the inflation rate is high in the US.
TLDR;
Inflation is caused by a lot of things. They are mainly classified into two; cost-push and demand-pull. Interest rates affect the supply of money in the economy, when the rates are low there is more cash in the economy. When rates are high, there is a reduction in the supply of money. An increase in the supply of money in the economy without a corresponding increase in productivity results in demand-pull inflation.
Readings
I spent the better part of yesterday reading, so here are some I enjoyed, I hope you do too. Also, if you can help with this; please don’t hesitate to reach out to me.
You merely adopted dark mode (it is not what you think it is)
See you next week, and have a fantastic week ahead.