Yesterday my wife asked me how
lower interest rates impact us aside from lower mortgage and lower fixed
deposit rates. Having studied economics in my junior colleague for 2 years and
another ½ year in university, I seems to know, but stumble to explain convincingly. Hence I decide to write a post on this topic.
lower interest rates impact us aside from lower mortgage and lower fixed
deposit rates. Having studied economics in my junior colleague for 2 years and
another ½ year in university, I seems to know, but stumble to explain convincingly. Hence I decide to write a post on this topic.
Lower Interest Rates -> Higher Aggregate Demand
Those who studied economics before
will know that Aggregate demand is the demand for the gross domestic product
(GDP) of a country, and is represented by below formula. In general AD
represents the GDP of the country without taking into account inflation.
will know that Aggregate demand is the demand for the gross domestic product
(GDP) of a country, and is represented by below formula. In general AD
represents the GDP of the country without taking into account inflation.
Aggregate Demand (AD) = C
+ I + G + (X-M)
+ I + G + (X-M)
C = Consumers’ expenditures on goods and services.
I = Investment spending by companies on capital goods.
G = Government expenditures on publicly provided goods and services.
X = Exports of goods and services.
M = Imports of goods and services.
R = Interest Rates
Lower R leads to Higher C & I
- Lower mortgage -> spur property
purchase -> increase C - Reduce incentive to save -> increase
C - Cheaper borrowing cost for firms
-> Aggressive expansion -> increase I
Lower R leads to Higher (X-M)
- Less attractive to save in the country
as better rates overseas -> less demand for local currency -> value of
local currency reduce -> Exchange rate depreciates - Export becomes cheaper relative to
other currencies -> increase X - Import becomes expensive relative
to own currency -> reduce M - Increase (X-M)
In theory, with the
increase in C&I and (X-M), AD will also rise, thereby increasing the real
GDP of the country. However it is not necessarily true, especially in times of
global recession.
May Not be True
In times of Global recession,
- Overall export demand will fall
- Rate of interests may be low, but
bank is cautious of lending - Consumer confidence will also be
low leading to lowering spending, despite the low borrowing rates. - If the country is experiencing
deflation, even if rate of interest is low, the effective real interest is
still high. - Time lag. E.g. most mortgage loan
has 2 years fixed period. The lower interest rate will only benefit you after
your existing mortgage loan expired. The same applies to company with loans are
already hedged over a period of time.
Lower Interest Rates -> Inflation
In general where the AD curve meets
aggregate supply, it determines the current level of prices and the employment
of resources (real GDP or real output).
aggregate supply, it determines the current level of prices and the employment
of resources (real GDP or real output).
Refer to graph below. If AD
increases, the curve it shifts to the right. Real output will increase. But price
level will also increase i.e. inflation.
increases, the curve it shifts to the right. Real output will increase. But price
level will also increase i.e. inflation.
In layman terms, it is not difficult
to imagine that increase spending in consumer, investment and export expenditure
will drive the prices of good and services up.
to imagine that increase spending in consumer, investment and export expenditure
will drive the prices of good and services up.
Who will Benefit in general
- Homeowners
/ Borrowers with lower mortgage / borrowing cost - Investors of companies. With lower interest rates, companies will have access to cheaper financing to accelerate their
growth plans. - Countries with lower proportion of saver.
Example US and UK with high level of mortgage debts. Singapore, China, Hong
Kong, Thailand and Malaysia also have high build up mortgage debt.
Note however that Singapore has no
external public debt as a country. China while having high debt is net
international creditor.
external public debt as a country. China while having high debt is net
international creditor.
On the contrary, US leads in the world with ~US$18
trillions of debt (106% of GDP), follow by UK with ~US$9.6 trillions (406% of
GDP). Refer to wiki here for list of countries by external
debt.
trillions of debt (106% of GDP), follow by UK with ~US$9.6 trillions (406% of
GDP). Refer to wiki here for list of countries by external
debt.
Note: 1000 Billions = 1 Trillion
Who will Suffer in general
- Savers.
Especially retirees who live on their savings in the bank. With lower interest
rate, leading to inflation, their real disposable income will be greatly
reduced. - Countries with higher proportion of
savers. - EU countries tend to rent more than taking mortgage loan, hence its less beneficial for them. For example, Germany’s
homeownership in 2013 is only 43%. Singapore’s homeownership is ~90%.
Impact on Current Account
Current Account Surplus = Export
> Import
> Import
Current Account Deficit = Export
< Import
< Import
As discussed earlier, lower interest
rates will devaluate local currency. In turn, exports are more competitive and
export demand will increase i.e. X > M, which means current account will
improve.
rates will devaluate local currency. In turn, exports are more competitive and
export demand will increase i.e. X > M, which means current account will
improve.
Good?
This is only true if the export demand
is relatively elastic. Not in times of global recession.
is relatively elastic. Not in times of global recession.
Please note on the other hand, lower
interest rates encourage spending. In doing so, spending on imports increase
and current account will deteriorate if this is true.
interest rates encourage spending. In doing so, spending on imports increase
and current account will deteriorate if this is true.
Furthermore if the country has huge debt
in foreign currency, the devaluation of its currency will resulted in more debts
in foreign currency. E.g. the depreciation of Rupiah against USD is not doing
Indonesia economy any good, because she has a debt of 26 trillions in USD. Read here.
in foreign currency, the devaluation of its currency will resulted in more debts
in foreign currency. E.g. the depreciation of Rupiah against USD is not doing
Indonesia economy any good, because she has a debt of 26 trillions in USD. Read here.
Therefore there is no certainty how
a country’s current account will be affected positively or negatively by the
interest rates.
a country’s current account will be affected positively or negatively by the
interest rates.
Rolf’s Summary
- In theory, low interest rate
increase aggregate demand only when global demand is elastic. - Low interest rate will lead to
inflation - Countries with high proportion of
spender over saver will benefit more. - There is no certainty how Interest
rate changes will affect a country’s current account.
Related Post:
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