Interest As Backbone of Modern Economy - Part 3
Posted: Saturday, November 14, 2009
by Shafi Farooq
http://mywebsiteworkout.com/personal-finances/
In modern world, especially the Western world and Japan, interest rate is considered the backbone of modern finances and that includes your family finances as well. It affects and impacts us all in every walk of life. Individuals and families ought to understand its importance.
The interest comes into play when we borrow money or lend money. Everyone is affected when the interest rate goes up or when it comes down. This backbone of the economy is controlled by the central bank of a country. In the U.S., it is called Federal Reserve Bank, commonly know as the Fed.
The Fed is responsible for keeping up the national economy running. It has a vital role in maintaining the health of the U.S. economy. The ways the Fed does so is by controlling different types of interest rates, depending on a variety of circumstances.
discount rate
This is actually the interest rate the Fed charges banks, including probably your neighborhood bank, on loans made to its member banks.
These days, the economy is sluggish. I think it has been called a lousy economy. In circumstances like these, the Fed can lower the discount rate and when it does, it creates somewhat of a ripple effect throughout the banking system. The lower rates make loans more affordable for its banks and in turn for the general populace.
That means a business can borrow money from its bank at a lower rate to boost its production to meet the demand of its products. That in turn creates more jobs.
federal funds rate
It refers to the interest rate banks charge each other for overnight loans. This loan has to be $1 million or more. But this type of interest rate can change very rapidly. It is also known as volatile interest rate.
A banker wakes up in the morning and the night before she needed at least a million dollars. So today she asks another bank to lend her bank the money. The interest on this kind of loan changes daily in response to the borrowing bank's need.
"effective rate"
REMEMBER Japan's zero interest rates? America is almost there too. Since October 29th 2008, the target for the federal funds rate has been at 1%, but the rate at which funds actually change hands, known as the <b>"effective rate"</b>, has averaged around 0.25%.
For example
At some point, the Fed determines that the economy is doing great. More and more people can borrow money at the lower rate. The economy is in full swing. Employment situation is just great. More and more people have obtained jobs. However, it is like you put a car in neutral on a downhill path and if you don't apply breaks, you will most probably get into an accident.
So what the Fed does is raise the <strong>discount rate </strong>so that more and more businesses and the general populace, eventually, will have harder time to get a loan. This slows down the economy a little which in turn will lower the inflation rate. There will be some job loss eventually. But as far as the Fed is concerned, that's probably OK.
The Fed as juggler
This way the Fed acts like a juggler. It is like a trapeze in a circus. The Fed has to keep the economy somewhere in the middle so that enough people will have jobs but not every human in the land who can work. 100 % employment is not good either for the economy. The Fed has to check the inflation rate as well. It has been said by the experts that at any time, the economy would be at its peak if the unemployment rate is above 2% but maybe below 4% or even 5%.
In a Nutshell
The discount rate plays a vital part in the economy at all levels. Big businesses, small businesses, individuals and families, one way or another, get affected by it. Unfortunately, some more than others. This juggling and trapeze kind of action has been going on for ages. Like I said previously, I am an immigrant and that's what I have seen over three decades.
What goes up must come down and, fortunately for all of us, the reverse has been true as well and repeatedly I might add. So let's hope we get out of this mess and let the responsible folks in the authority position add some hooks and nooks in the economy that next time the adverse effect is not so overwhelming on businesses, big and small, and especially on the general populace, on us folks.
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