Interest Rates

Do you know that an interest rate is the price charged by the owner of the money to rent that money to the borrower?

Grocer Bob’s bananas were $1.00 a pound several months ago. He could not sell more than 20 pounds a week. So two months ago Grocer Bob lowered the price to $0.50 per pound. He sold an average of 100 pounds each week over the following weeks. It looks like Grocer Bob will now make more profit from banana sales than he has in any recent period.

Grocer Bob is so smart that he lowered the price of bananas to $0.25 per pound a few weeks ago. He expected to sell 300 pounds per week. Grocer Bob is a wise businessman because he understands the concept of lowering prices to entice more buyers into his store.

When Grocer Bob lowered the price of bananas to $0.25 per pound he expected to sell 300 pounds. But Grocer Bob sold only 60 pounds.  Perhaps sales fell because people had less desire for bananas since their appetites got smaller for some unknown reason.

When interest rates were 6% many people borrowed money. When interest rates dropped to 5% fewer people borrowed money. This may be because fewer people were optimistic about what they might do with borrowed money to earn profits or improve their life. A decline in borrowing can precede, and even promote, development of a business slow down — a recession.

In this context, interest rates could fall to 4%. If rates do fall, it will indicate that there is not enough demand for money to support the 5% price to borrow money.

Years ago many people were willing to pay over 7% to borrow money.  They were willing to pay 7% for the chance to deploy borrowed money to reap an even bigger reward or improve their life. That indicated that people were optimistic.

If people feel there is a relatively big risk, they may borrow money, but only at a lower rate. If people feel there is a relatively low risk, they may be willing to borrow money at higher rates.

If there is a recession, rates will trend lower because fewer people will borrow money for cars, houses, business ventures, and investments.

If there is a recession, rates will go lower because fewer consumers will buy products and services. This implies fewer people will need to be employed manufacturing products and providing services to those fewer customers.

If there are fewer customers buying goods & services, and fewer workers earning wages, the decreased buying power and demand will lead to lower prices for many products and services. If prices continue to fall, even fewer people will be working, there will be even fewer potential customers with even less money to spend.  This is deflation.

In a deflationary environment, the demand for investment capital from the stock & bond markets declines. This implies stock & bond prices may be lower. That is because any already issued stocks & bonds will be in decreased demand.

Such a deflationary process will continue until it reaches a bottom. Then people will start regain jobs, earn money, start buying, the economy will grow, and people may again return to complaining about inflation.

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