Interest Rate Policy Key Terms

Nominal Interest Rates

• These are the stated interest rates that do not account for inflation.

• These are the rates that banks charge for loans only.

• These are the rates that are adjusted for inflation.

• These are the stated interest rates, which, when combined with inflation rates, determine real interest rates.

Limitations of Interest Rate Policy: Insensitivity to Interest Rate Changes

• Consumption (C) and investment (I) can be insensitive to changes in interest rates due to other more important factors affecting them.

• Interest rates have a direct and immediate effect on consumption and investment decisions.

• Changes in interest rates always lead to proportional changes in consumption and investment.

• Interest rate policy is the only factor influencing consumption and investment.

Interest Rates

• Interest rates are the fees paid for using someone else's money.

• Interest rates are the rewards given for saving money.

• Interest rates are the costs associated with borrowing money.

• Interest rates are the penalties for late payments.

Limitations of Interest Rate Policy: Liquidity Trap

• Occurs when the Central Bank can effectively stimulate consumption and investment.

• Occurs when the Central Bank may not be able to reduce interest rates further, especially when the nominal interest rate is already near zero or at zero.

• Occurs when the Central Bank increases interest rates to control inflation.

• Occurs when the Central Bank has unlimited capacity to lower interest rates.

Real Interest Rates

• Real interest rates are equal to nominal interest rates plus inflation rates.

• Real interest rates are equal to nominal interest rates minus inflation rates.

• Real interest rates are the same as inflation rates.

• Real interest rates are always positive.

Limitations of Interest Rate Policy: Time Lag

• The time lag can lead to policy ineffectiveness due to implementation and response delays.

• Interest rate policy has no limitations and is always effective.

• Time lag only affects fiscal policy, not interest rate policy.

• Interest rate policy is implemented instantly without any delays.

Expansionary Interest Rate Policy

• This policy is adopted by the central bank when the economy is heading towards a recession with a high level of cyclical unemployment. It involves lowering the interest rate.

• This policy is implemented to increase interest rates to control inflation.

• This policy is used to stabilize the currency by raising interest rates.

• This policy aims to reduce government spending to boost economic growth.

Effects of Lower Interest Rates on Firms

• Lower borrowing costs lead to decreased investment opportunities.

• Lower borrowing costs may make investments more profitable, encouraging more investment.

• Lower interest rates have no effect on firm investments.

• Lower borrowing costs result in higher operational costs for firms.

Effects of Lower Interest Rates on Households

• A lower interest rate increases the cost of borrowing for households.

• A lower interest rate decreases willingness to borrow and encourages saving.

• A lower interest rate reduces the cost of borrowing and encourages more household spending.

• A lower interest rate has no effect on household spending.

Impact of Decreased Consumption and Investment

• The decrease in consumption and investment leads to an increase in AD, resulting in a rise in real national income and a rise in the general price level.

• The decrease in consumption and investment leads to a decrease in AD, resulting in a fall in real national income and a fall in the general price level.

• The decrease in consumption and investment has no effect on AD, real national income, or the general price level.

• The decrease in consumption and investment leads to a stable AD, resulting in unchanged real national income and price levels.