Tuesday, September 23, 2008

Interest Rates

So I wanted to post something about the potential bailout package, but I couldn't see how to explain it without referring to the Fed, and why the current crisis is beyond the Fed's ability to manage.  So I figured I would post something first about the Fed, but that I couldn't see how to explain the Fed without referring to interest rates, and what they mean, and why they are important.  So I ended up here, starting with a post about what interests are, and why they matter to the economy.

Let me start with a question: will you trade me $1 for $1 right now?  It would be kind of dumb, but why not? $1 is $1.

Now, let me ask a different question: will you give me $1 right now, and I'll give you $1 one year from now?  No?  And why wouldn't you give me $1 today for $1 in a year?  They're both dollars, right?  The problem is that you will now have to wait one year to spend your $1, rather than spending it today.  And $1 a year from now is not as fun as $1 today.  So you refuse the offer.

Now, let me ask another question:  will you give me 50 cents right now, and I'll give you $1 one year from now?  Why is the answer now likely to be 'Yes'?  Because now you are being compensated for giving up your money today and waiting one year for it.  Since $1 in a year is equal in value to $1/2 today, the price of future money is equal to 1/2. 

The price of future money can be summarized as P(future) = 1 / (1+r), where "r" is the interest rate.  Does this work?  Well, if our price of the future is 1/2, then r = 1.  In other words, the interest rate is 100% - and this is actually what we have: if you give me 50 cents, I pay you the 50 cents plus 100% interest (another 50 cents) next year, for a total of $1.   If the interest rate were 10%, then the P(future) = 1 (1 + 0.10) = 0.909, or it is much cheaper than when the interest rate = 100%.

The point is that interest rates determine the price of future money.  If r goes up, then the price of the future goes down, and you'll "buy" more future money by saving your money today.  If r goes down, then the price of the future goes up, and you'll "buy" more current money by spending it today.

If the price of future money gets really low (r gets big), then everyone decides to "buy" money in the future, and starts saving their money.  Which means they stop spending money today - and if they stop spending money today, economic activity will be less today (i.e. a recession if things slow down enough).   To keep the recession from happening, we need interest rates to go down, so that the price of future money goes up, and people decide to "buy" less future money and consume more money today.

So when the Fed sets interest rates, it is trying to change the price of future money, and either get you to move your consumption from the future to today, or from today to the future.  Which now gets us into how the Fed actually accomplishes this change in interest rates.

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