In our last lesson we learned about the business cycle, why it is important in trading, and how the government tries to influence the business cycle through something known as Fiscal Policy. In today’s lesson we are going to begin to learn about monetary policy with a look at one of its key components, interest rates.
Interest rates at their core are the payment that a lender requires from a borrower in return for lending them money, normally stated as a percentage of the amount borrowed. If for example a lender makes a loan to a borrower of $100 for 1 year at an interest rate of 6%, then the interest payment and therefore cost of that loan for the borrower is $6.
Interest is normally made up of the following components:
1. The Time Value of Money: Under normal circumstances most people would prefer to have $1 given to them today rather than that same $1 given to them 1 year from now. The reasons here include the fact that if you have the dollar today then you can put it to work and potentially increase the value of that dollar over the next year or you can go ahead and buy something that you want now with your dollar rather than having to wait a year. As this is the case a lender is going to expect to be compensated for not being able to use the money he or she lends for a set period of time.
2. Inflation Expectations: If prices are expected to be higher 1 year from now than they are today, then a lender of money is going to want to be compensated for that loss in value over the term of the loan.
3. How much Risk there is that a loan will not be paid back. If a lender, for example, is lending money to someone he knows very well, has lent money to in the past and been paid back, and the loan amount is much smaller than his or her income, then that lender is going charge a lower interest rate than he will to someone that is not such a sure bet.
As most of you already know people borrow money for a number of reasons some of the most common of which include:
1. To buy a house (something known as a mortgage)
2. To start or expand a business
3. To buy consumer products (with credit cards)
Because borrowed money makes up such a large percentage of spending in the US and many other countries, how easy and cheaply the general population can borrow money has a large effect on economic growth. As this is the case, in general when interest rates are expected to go higher (making it more costly for people to borrow and spend money) people will be expected to borrow and therefore spend less money, and economic growth will be expected to slow as a result. Because of this in general when interest rates are expected to rise the stock market will sell off in anticipation of slower overall economic growth.
Conversely, when interest rates are expected to go lower (making it cheaper for people to borrow and spend money) they will be expected to borrow and spend more money and economic growth will be expected to rise. In anticipation of higher growth the stock market will normally rally all else being equal.
To get an idea of just how much even small changes in interest rates can affect things consider this as an example:
The payment on a $500,000 Mortgage at an annual interest rate of 6% is $2998 per month.
If the interest rate is 8% instead of 6% however you now pay $3699 per month which is about $700 more per month, $8400 per year, and $252,000 in additional payments over the life of that same loan.
So you should now have a good understanding of not only what interest rates are but also the important role that inflation plays in not only making goods more expensive but also in the cost of borrowing money.
In our next lesson we are going to further our discussion on interest rates, monetary policy, and learn about one of if not the most powerful institutions in the financial markets, the Federal Reserve, so we hope to see you in that lesson.
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