How does interest rate influence consumption in the United States of America?
Introduction
Interest rates are the rates at which borrowed money is paid back to the lender by the borrower. This interest rate is a percentage of principal sums paid over and above the amount borrowed. Interest rates are the critical tools for monetary policy control and are heavily relied upon when dealing with such variables like unemployment, investments and inflation. The government through the Federal Reserve Bank reduces interest rates to encourage and increase investment and consumption in the general economy.
Interest rates in most instances affect savings and the general consumption inversely. That is, there is a negative state of correlation between consumption and the interest rate. When interest rates rise the average household saves more to make use and take advantage of the high interest and consumes less out of their current income as they prefer to save most of it. Savings can also be considered as be considered as postponed consumption.
People will only save if they are paid much more than what they currently need. In short, in the long run, the higher the interest rate the less savings will occur as businesses will pass the high cost of borrowing to the consumers who will eventually reduce their spending habit which will lead to a drop in sales and result in losses for the companies who will react by retrenching some employees leading again to less consumption because of lack of income and a recession will definitely set in because of these circle of events. For instance, when the consumer financing increased their cost due to an increase in interest rates it highly discouraged the use of credit cards.
Adjustments in interest rates are used to adjust, control and maintain inflation within an acceptable limit for a sound and healthy economy in order to spur economic growth. When implementing the monetary policy through adjustment of interest rates i.e. increasing or decreasing the rates to affect or alter people and company’s demand for products and services.
The long term interest rate usually reflects and shows what people in the financial market expect from the Federal Reserve Bank to do in future. If the people’s view is that the Federal Reserve Bank is not doing enough to control and maintain inflation, they will add a premium risk to long term rate as a provision to shield them against the expected increase in inflation. These will push the interest rates further higher. The inflation premium is the provision for expected effects of inflation expected by the investor given the prevailing economic conditions.
Changes in the real interest rates influence the public’s demand for the products and services mostly by adjusting the costs of borrowing, the loans available for investors, the rates of foreign exchange, the wealth and purchasing power of the average household in the economy. For instance, when there is a decrease in the interest rates it lowers the cost of interest for the loan borrowed which allows businesses and large corporations to increase investments and further leads to more spending on durable goods by average households in the economy.
The low interest rates and the favorable economy increases the average commercial banks reserves which leads the banks to encourage small businesses and households to take loans by offering good borrowing terms and low interest rate. These increases spending habits especially for the average income earners who opt for the banks as a source of credit. (Sullivan and Sheffrin, 2003)
Low interest rates make the common stock and direct investment more favorable and attractive than bonds which results in the increase in common stock prices. Households and companies with stocks and similar investment experience a higher value in their holdings which increases wealth and boosts them to spend more. This increase in the value of stocks also encourages and makes it attractive for small and big firms to invest in plants and equipment by the issue of stock.
The low interest rates in the US, in the short run, reduces the value of the dollar in the foreign exchange market that lowers the average prices of the goods manufactured in the US which are being exported and sold abroad while the imports prices increase i.e. goods manufactured abroad and sold in the US become more expensive. (Deventer, Imai and Mesler, 2004)
When there is an increase in general spending the rate of consumption also increases. These also increases demand for the output of the economy. The companies in the economy have to increase production and also employment, which also raises the level of spending on durable goods. Due to the increase in employment, consumption is also boosted further.
Wages and prices will eventually begin to rise at an increasing rate if the monetary policy stimulates and favors the combined demand and pushes labor and the capital markets over their long term capabilities or capacities. A monetary policy that is persistent at maintaining low short term real interest rates will eventually lead to a high rate of inflation and also increased nominal rates of interest without any permanent and effective increases in the corresponding growth and output or any meaningful drop in unemployment levels. Output and unemployment rates are rarely directly affected by the monetary policy in the long run as the tradeoff between the high inflation and unemployment rates in the short run is eroded and disappears in the long run. These affects consumption as when inflation rises the value of the dollar decreases making it cheaper for foreigners to invest in the US market. These investments lead to more employment opportunities which increase consumption in the US.(Deventer, Imai, and Mesler, 2004)
For instance in the year 2008 and parts of 2009, when the US economy recorded a negative 8% growth, www. research.stlouisfed.org/publications/iet/, the employment level during that period was at an all time low which stood at negative 4% growth while unemployment was at 10%. The composite of long term government bonds stood at 4.5% while the three months CDs stood at slightly over 3% that nose dived to almost 0.1% in 2009 while the GDP was at its lowest growth negative growth of 4.5%.
The health and state of the economy also affects interest rates and consumption by influencing the supply and demand for credit. When the economy is an a recession, the general income of the average household reduces and the amount of saving also reduces by the same margin. The need for credit by businesses generally reduces in a recession as most companies spend less money on new investments, buildings, equipment and stocks these is due reduced demand by the general public which leads to very low consumption of goods and services. During this period the interest rates are normally excessively high and the Federal Reserve will most likely reduce interest rates to encourage economic activity which eventually will lead to more consumption.
The federal government also needs credit during recession as the low consumption and reduced business activities, i.e. low investment, reduced expansion in fixed assets and capital expenditure leads to reduced tax revenues while other spending on unemployment insurance increases, the pressure for the government to act also increases. This compels the government to reduce its interest rates charged on commercial banks to expand and create more credit facilities to the public. These will attract borrowing which will again lead to more consumption.
As a result of low interest rates, real estate development took a slump during the recession in the year 2007 and recovered gradually when interest rates started recovering. The low interest rates during the period to some properties being overvalued which benefitted only the construction industry.
Wages and consumption are interrelated which are tied to employment. Without employment consumption will be negatively affected. The existence of the decreasing trend in the nominal wage difficulties bends and affects the short run wage Philips curve. The slopes and curvature of the Philips curve is influenced and depends on the level of inflation and the nature of the original wage rigidities. When analyzing the US wage and employment changes from the great recession, it reveals that the decreasing trend of the original wage difficulties have shaped the dynamics of unemployment since the year 2006 to the year 2012, these trends have also affected the consumption.
In California the job growth rate in the past two decades has been gradual compared with the rest of the country. However the output in terms of GDP has been growing faster than in any part of the country. One factor for these has been the growth of jobs with high pay at the expense of the low paying jobs which has contributed more to the growth rate than the employment rate. This creates more opportunities for the skilled labor and few for the semi skilled. These explained why there was high consumption rate in California during the last two decades while at the same time unemployment rates were also high. (Homer, Sylla, 1996)
The interest rates are the tools of the US monetary policy that influence all kinds of financial and economic decisions people make i.e. whether to buy a house or a car or start up a business. The main aim of adjusting the interest rate is to influence the way the economy is performing which is mainly reflected and revealed in such factors as inflation, GDP, and employment. It affects the demand of goods and services across the entire economy. This demand is the people and firms’ ability and willingness to spend and increase consumption.
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