Interest rates & the economy

Interest rates

• Central banks often change their target interest rates in response to economic activity
• Raising rates 
• when the economy is overly strong
• Lowering rates 
• when the economy is sluggish
• Lowering rates
• Makes borrowing money cheaper. 
• This encourages consumer and business spending and investment and can boost asset prices
• Lowering rates, however, can also lead to problems such as inflation and liquidity traps
• c.f. Liquidity traps
• A contradictory economic situation in which interest rates are very low and savings rates are high, rendering monetary policy ineffective
• During a liquidity trap, consumers choose to avoid bonds and keep their funds in cash savings because of the prevailing belief that interest rates could soon rise
• The lower the interest rate, the more willing people are to borrow money to make big purchases, such as houses or cars. 
• When consumers pay less in interest, this gives them more money to spend, which can create a ripple effect of increased spending throughout the economy. 
• Businesses and farmers also benefit from lower interest rates, as it encourages them to make large equipment purchases due to the low cost of borrowing. 
• This creates a situation where output and productivity increase.
• Raising rates
• Higher interest rates mean that consumers don't have as much disposable income and must cut back on spending. 
• When higher interest rates are coupled with increased lending standards, banks make fewer loans. 
• This affects not only consumers but also businesses and farmers, who cut back on spending for new equipment, thus slowing productivity or reducing the number of employees. 
• The tighter lending standards also mean that consumers will cut back on spending, and this will affect many businesses' bottom lines.
• c.f., bottom line
• A company's earnings, profit, net income, or earnings per share (EPS).
• When inflation
• Inflation
• Refers to the rise in the price of goods and services over time. 
• It is the result of a strong and healthy economy.
• To help keep inflation manageable, the Fed watches inflation indicators such as the Consumer Price Index (CPI) and the Producer Price Index (PPI).
• c.f., CPI
• A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. 
• It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. 
• Changes in the CPI are used to assess price changes associated with the cost of living. 
• The CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
• c.f., PPI
• A group of indices that calculates and represents the average movement in selling prices from domestic production over time.
• The PPI measures price movements from the seller's point of view. Conversely, the consumer price index (CPI) measures cost changes from the viewpoint of the consumer.
• When these indicators start to rise more than 2–3% a year, the Fed will raise the federal funds rate to keep the rising prices under control.
• Because higher interest rates mean higher borrowing costs, people will eventually start spending less. 
• The demand for goods and services will then drop, which will cause inflation to fall. 
• How affecting stock and bond market