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Managing Interest Rates

A commonly seen headline in media is “Central bank increases the interest rate….”

(1) Is the rate that is increased the nominal rate or the real rate?

(2) What is the effect does the real interest rate and the nominal interest rate have on inflation?

(3) What happens to GDP if the real interest rate is decreased (if it can be decreased by the central bank) or decreases?

(4) What is the feasibility of achieving low inflation and high GDP growth for a country?

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1) The stated rate is nominal, but in practice both the nominal and real rate would increase unless you’re in a hyperinflationary environment were inflation is outpacing rate hikes.

2) Interest rates are used as a tool to (attempt) to control inflation. As inflation heats up (in the U.S. this would be when it’s over 2%) the Fed starts to get worried and raises rates. By raising rates, people/institutions become more likely to invest in shorter term bonds than in riskier assets (stocks, capital expenditures, etc.) thereby slowing the economy and hopefully inflation. Once inflation normalizes (normally because the economy slows down), the Fed relaxes and lowers rates to start the cycle over again.

3) The real interest rate can decrease either by nominal rates holding steady and inflation ramping up, or by inflation holding steady and nominal rates decreasing. The former happens when the economy is expanding but before the Fed takes action to raise rates (towards the end of an economy’s expansionary phase), while the latter occurs when the Fed decides to “ease” rates because they’ve met their objective of keeping inflation in check. At this point in the economic cycle, we’re likely in a late recessionary or very early recovery phase.

4) On a perpetual basis? 0%. Healthy economies have to grow and retract (or at least slow). You can’t have an economy where it does nothing but grow forever. Wages would increase which would increase demand which would result in higher prices (inflation).