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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 -> 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.

Aggregate Demand (AD) = C
+ 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).
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.
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.
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. 

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.
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
Current Account Deficit = Export
< 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.
Good?
This is only true if the export demand
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.
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.
Therefore there is no certainty how
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.


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One thought on “How Interest Rates Impact Us

  1. Most of the time people afraid to take loans only because of the high interest rates. But if you want to take this loan through the help of mortgage lenders then best mortgage rates whitby is waiting for you to give you the best interest so that you could able to repay the loan easily.

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