The Effect Of Interest Rate

Published Date: 02 Nov 2017

The topic has been divided into a series of parts so as to make a coherent approach in developing the dissertation. The following parts along with a brief explanation, makes up with this dissertation.

Introduction: The dissertation begins with providing an introduction about the topic and a brief insight as to the explanation of this topic and its possible implications. For instance, the role of the central bank has been explained which controls the money supply, which in turn is the key influencer of the interest rate. Likewise, the definition of the interest rate has been provided. Further, a relation has been developed between the interest rate changes and its possible implications on the business expenses. The Introduction is finally concluded with a brief explanation of the economic theories in relation to the dissertation.

Literature Review: The next segment focuses upon the use of the work on the economic theories in relation to the topic. This include the commenting and explaining the work of AW Phillips who created the theory of Phillips Curve and making use of other economic concepts like Wage-price spiral. These theories have been discussed in detail and in the end of this segment are related to the topic so as to create relevance of the use of theories in this dissertation.

Further, the impact of this topic is also considered in categorization of the different types of businesses such as manufacturing and retail types of businesses so as to develop a better understanding of the possible implications of this topic to every kind of businesses.

Methodology and analysis: This part of the dissertation focuses upon the use of primary data gathered to comment upon this topic along with the positive and negative implications of making use of primary data. Types of analysis would include looking into macroeconomic insights (such as discussing the impact of interest rates on GDP and GNP), before giving a deeper insight into industry specific analytics. Finally, using this analysis it would be judged whether if and to how extent the changes of interest rate effect the business expenses.

Conclusion: The final part of the dissertation is concluded with providing a conclusion, whose basis would be based upon the material used in preparing the literature and methodology and analysis section of this dissertation. There would be arguments presented in a summarized form at the end to give a snap shot of the entire workings in the dissertation as this would help the readers too to facilitate while reading this dissertation.

Introduction

The Central Bank is considered to be the main pivot cog that regulates the money supply in the country. Central Bank is a financial institution charged with the responsibility to manage the regularity of the size of a nation’s money supply, the management of providing credit and at the same time keeping a check on the foreign exchange value of its currency. (Merriam Webster, 2012)

The roles of the central bank however vary from country to country but all that had in common includes the addressing of the issues such as:

The extent of the central bank’s ability to design policy and to implement these policies. They would also cover addressing issues which includes determining the exchange rate policy and the setting of the objectives that includes both monetary and exchange rate policies.

The extent of the central bank’s ability to hold the responsibility for the financial stability of the whole country. This would include addressing the questions as to the instruments available at its disposal to discharge its responsibilities.

How the central bank did would ensure a balance between the various infrastructure systems that are the pillars to support the payments and the settlement systems.

What are the other financial and non-financial functions that would fit with the overall monetary and fiscal policy and the financial stability task? (David Archer, 2012)

To demonstrate a real life example, I am illustrating the scope and function of the Central Bank of England.

The Bank of England purpose is to ensure the provision of monetary stability and to contribute towards the financial stability of the country. (Bank of England, 2012)

Among these objectives two main core purposes have been established that addresses each of the purpose mentioned above.

Monetary Stability:

Monetary stability, as the name denotes, represents the stability of the price level within the country along with maintaining focus on keeping the confidence in the currency. The price levels/ targets are set by the Government’s inflation target which then the Bank work towards the meet those target explaining the efforts made towards reaching that goal and communicating it transparently in the money markets.

Financial Stability:

This aspect looks at the protection of the overall financial system which includes the Bank’s financial and other operation including acting as a lender of the last resort.

In attaining both of these objectives the central bank work closely with other central banks, international organizations, HM Treasury and the Financial Service Authority which has to be pursued under the terms of the Memorandum of Understanding, to pursue financial stability. (Bank of England, 2012)

Interest rates are considered to be an important economic tool to achieve the desired government objectives. The Central Bank may influence the supply and demand of the. Interest rates are often considered as a major macroeconomic tool to influence the achievement of the government’s objective relating to the control of inflation rate within the economy, influencing and controlling the level of unemployment within the country and to influence the exchange rates of either the national or the foreign currency.

Interest rates

Interest rates are defined as cost of borrowing money. It is the return the lender is expecting against its ‘investment’ provided to the borrower.

Princeton defines interest rate as the percentage of a sum of money charged for its use. (Princeton, 2013)

Types of interest rates

There are two different types of interest rate. Real interest rate and the nominal interest rate.

Nominal interest rates are defined as the rates quoted in loan and deposit agreements. On the other hand real interest rates are obtained by deflating the nominal rates, that is to say, by adjusting them for the decrease in the real value (i.e. purchasing power or the time value of money) of the borrowed or deposited funds over the duration of the loan or deposit. The decrease in the real value of the funds over a given period therefore represents the inflation rate for that specific period.

Ex post approach is defined as when the deflation is performed after the loan or deposit period has ended. It is here that the decrease in the real value or the inflation over the period of the duration of the loan or deposited funds is actually measured. The way of calculating the real rates in this manner are called ‘ex post real interest rates’. Similarly, when the deflation is carried out before the end of the loan or deposit period it is referred to as the ex ante approach. Here, we are compelled to use the expected decrease in real value, that is, we deflate by the expected rate of inflation for that period. Rates calculated in this way are termed "ex ante interest rates". Various economic factors may affect the real rate of interests for any provided nominal rate depending on the expectation of inflation or depending upon the measures of inflation they are using for deflating.

If the nominal interest rate and inflation rate are low, deflation can be calculated approximately by subtracting the actual or expected inflation rate during the loan or deposit period from the nominal interest rate. However, in order to calculate the real interest rate accurately (for any nominal interest rate and any rate of inflation), the following equation is used:

r = [(100 + R)/(100 + i) - 1]*100, 

where 

r = real interest rate (in %) 

R = nominal interest rate (in %) 

i = actual or expected inflation rate (in %) (CNB, 2013)

Use of interest rates in influencing other macroeconomic indicators

The rationale behind charging the interest rate is to compensate the lender for the loss of the asset’s use or the opportunity cost of not using the money he has.

Businesses are interlinked with the changes in the economic environment of the country in which they operate. Changes at the economic level could either impact them directly or indirectly depending upon how much the activities of the business are tied up with that particular economic indicator and how it responds to a change in its level.

Likewise, changes in the level of interest rate have direct and indirect impact upon the business. The interest rates however, have the largest impact on long term businesses where investment income forms the major portion of the earnings for a business. (Swiss Re, 2012)

When correlating the relationship between the interest rate changes and its impact on the business expenses, it is important to distinguish of which of the business expenses are affected directly and which would be affected indirectly.

International Accounting Standard 23 defines finance costs as ‘interest and other costs that an entity incurs in connection with the borrowing of funds’. (Ready Ratios, 2013)

The finance costs therefore includes the interest expense on the loans taken out by a company and includes other items which consists of finance charges on the finance lease, exchange differences etc.

On the other hand there may be instances where finance costs could be associated with capital expenditures being undertaken by the businesses. Generally, the companies tend to pursue growth by spending on capital expenditures to improve their fixed assets turnover for the current business or to avail an opportunity to exploit new profitable market segments. Whatever the reason maybe for growing it is evident that the companies tend to pursue a combination of debt and equity to incur the least cost of capital, which would ultimately leads to higher profits from the project being undertaken.

The interest rate therefore plays an important role in determining the outcome of the investment project and how it can influence the finance costs of such projects.

Non finance costs could be described as expenses incurred on the activities which exclude the financing of the business.

They would therefore encompass every sort of expenditure which the company would be undertaking other than that of the finance costs.

Interest rate change has an indirect impact on the non finance costs as determined by the following para:

In relation to the wholesale prices in Hamburg and England and the central bank’s interest rate and the interest rate in the open market in London and Berlin, Wicksell wrote that, ‘it must be admitted that if it is possible to discover any connection between them all, it is that a high rate of interest is associated with high commodity prices and a low rate of interest with low commodity prices, rather than the other way round. Faithful to the principle we established earlier, however, we are not going to let ourselves be put out by this circumstance but, for the time being, we shall test the theory itself on grounds of logic’. (Wicksell, 1898, p.78)

This quotation from Wicksell clearly indicates a positive correlation between rate of interest and the inflation rate, which is now referred to as Gibson’s paradox.

The Gibson’s paradox can be illustrated with an example to exactly know how this relation between interest rate and the inflation rate is developed.

Consider a company producing food products. The company finds a need to expand or to finance its working capital requirements to meet its liabilities as they fall due, in search for the sources of finance, the company approaches a bank and enters into a loan with a variable interest rate.

The loan is payable over a period of, for instance, five years. The company uses the loan facility to finance out its working capital requirement or to undertake the investment projects. In some time, interest rate rises and so does the cost of borrowing for the company. With keeping ceteris paribus constant, the company passes of this increase in cost of borrowing towards its increased sales price (as we assume that company wants to maintain constant gross profit margin). The result is that, the increase in interest rates are passed out in the form of increased prices for the commodities hence, resulting in inflation.

The impact of rising prices as mentioned above does not restrict to only this situation, consider the macroeconomic theory of ‘wage-price spiral’.

(A short explanation for some macroeconomic models, that would be used in this dissertation, are mentioned below, just to demonstrate how inflation impacts different aspects of business, although a more detailed explanation would be provided in the literature section)

The ‘wage-price spiral’ provides explanation to the cause and effect in the form of relationship between rising wages and rising prices, or inflation.

Also called cost push inflation, the general idea behind wage spiral is when inflation has increased the general price level of commodities the union, generally powerful workers union, claim to compensate the increased price levels in the form of increase wages as to maintain the current level of real income.

If the wages are increased the, increased costs to the company is passed down in the cost of production and assuming that the company keeps constant gross profit levels, the prices of commodities are increased again. Workers would again demand a rise in pay to compensate the increase price levels and so this ‘spiral’ continues to grow.

Another macroeconomic theory, called Phillips curve could be used to demonstrate the relation between unemployment and the inflation rate.

Study of A.W. H. Phillips’s in relation to unemployment and inflation has found that there is an inverse relationship between the inflation and the unemployment rate. When the unemployment rate is high, the inflation rate is low and when unemployment rate is low, the inflation rate is high. The details and explanation would be looked and discussed in the following sections.