Learning Outcome Assessment

INTEREST RATES AND THE FUNCTIONING OF THE FINANCIAL SYSTEM
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Interest Rates and the Functioning of the Financial System
1. Factors that influence the interest rates
1.1. Monetary policy
Like all other nations, in the United States the interest rates are determined by the central bank, in this case, the FED. The Federal Reserve is the economy’s watchdog and interest rates are by far a key component of the economic well-being of a country. The interest rates can be controlled by the exercise of the following powers as charged by law, the power to control and change when the need arises the discounting factor, power to increase or decrease the interest and mandate all commercial institution to take up the new interest and open market operations where they sell government paper.
The Federal Reserve tightens its monetary policies to ensure less economic liquidity thus increase the interest rates. And loosens the monetary policies and increase the money supply in an economy to bring down interest rates.
1.2. Economic growth
When the economic growth of a country improves then there is more demand for money. This increase in demand for money causes a direct increase in the interest rates.
1.3. Inflation
Inflation is the progressive increase in prices of goods and services in an economy over a long period of time. Inflation increase has the effect of raising interest rates. The interest rates rise because as the inflation increases the purchasing power of money decreases.

When this happens investors try to protect their future returns by asking for higher interest rates to curb the inflation. This is also because inflation has a detrimental effect on the future value of money.
1.4. Global liquidity
Liquidity is the amount of money in supply to the economy. When this amount of money is high in the world then it gives that most likely the liquidity of a country is also just as high. High liquidities have an effect of enacting an upward push on the interest rates of a country.
2a. Yield Curves
A yield curve is a locus of points of interest rates at a given point in time of bonds that accrue the same credit or are of the same value but different dates of maturity. In the US the most prevalent yield curve compares three months and two-year treasury debt. This curve is used as a platform for evaluating mortgage rates, bank loan rates and to predict changes in economic productivity and growth.
There are in existence three types of yield curves. These are the normal yield curve, the inverted yield curve, and the flat yield curve.
2.1. Normal yield curve
This is an up-sloped curve that indicates that long-term bind rated may continue to go up. This is usually in response to economic expansions taking place at that time. Investors expect that long-term interest rates will be higher than so they invest heavily in short-term securities with the hope of acquiring the long-term securities when their rates hike in the future and thus acquire higher returns.
According to the pure expectations theory of interest, an increasing yield curve structure ensues that the interest rates in the short run will tend to rise. On the other hand, a declining structure presupposes that the market believes that the interest rates are going to remain low.
This relates to the normal yield curve as it states the reason why the investors find it risky to invest in long-term securities when their prices are high even in the face of high yields.
2.2. Flat yield curve
This yield curves transitions from normal to inverted curves. It is highly dependent on the economic well-being of the country’s financial systems. In times of recession or slow development when the long-term bonds yield lower returns than the short-term bonds but are in more demand, then the curve becomes inverted. On the other hand during the period of economic flourish, growth and expansion then the curve transitions into a normal curve.
This phenomenon can be explained using the market segmentation theory of interest. Under this theory, any type of curve can occur. The shape of the curve is then dependent upon investor action and market expectation.
2b
2.1. Benefits of the assignment and how to overcome challenges when working as a group
The biggest and most important benefit accrued from the completion of this assignment is the raised knowledge and awareness I attained about the financial systems of the nation and how it influences consumer, firm and government decisions. From this knowledge, I am now able to plan better for my investments and spending from a more informed perspective.
Working in a group is never an easy task to go around. There are varied personalities, ideologies and belief systems in the multitude that comprise a group. With this, there comes a number of challenges that follow. In the group, the issue of meeting deadlines was faced. Different members of the group worked on the workload given to them at different paces.
Distribution of the work given was also an issue. Some members claimed to be receiving the largest part of the workload. This created a lot of conflict within the group and when tension was high very little in terms of productivity was achieved.
To solve the problems that riddled the group we formed a system of initiating group motivation and increased tolerance. This enabled us to see the diversity within the group as less of a hindrance and more of a blessing. With the changed attitude the group’s productivity went to an all-time high and tasks were achieved much quickly and with less effort than before. Another system was adopted. In this system, the group came up with short-term goals. This made the workload seem easier to work through and also helped in its division. Thus tension and conflict in the group were minimized.
2.2. Effects of raised interest rates
The US Federal Reserve may be prompted to increase the interest rate in an effort to curb inflation. Inflation occurs when the current supply does not match up the current demand. This causes asset prices to increase. When the consumer spending income is brought down due to increased interest rates, then their demand is inversely brought down.
The effects of increased interest rates include;
Reduced confidence
High-interest rates make both investors and consumers wary of taking up risky investments or purchases. This results in reduced consumer and investor confidence
Increases the cost of borrowing
Interest payment on any loan is increased. This discourages people from taking up loans, and those who have loans already will have very little disposable incomes. This has the economic effect of reducing consumer expenditure.
Increased incentive to save
Bank account savings will yield greater returns and thus the general population will be more inclined to save than to spend.
Government debt interest payments increase
The increased interest rates force the government to pay more on its national debt. This may lead to consequences such increased taxation so as to fund the debts.
2.3. Effects of lowered interest rates.
The FED may choose to lower the rates of interest so that they can stay in a country
Encourage economic expansion
People are able to access funds for capital projects and expansion projects more cheaply. Investment then results in economic expansion.
Combat deflation.
Deflation is a period where there are consistent price drops. If this negative inflation is caused by a lack of demand then an increase in money supply due to reduced interest rates will be able to fix that.
Increase economic liquidity
As earlier explained liquidity is the amount of money in circulation in the economy.
These are some of the effects of lower interest rates;
Reduces the incentive to save
Lower interest rates reduce the overall return from saving. Thus a person would desist from saving since there is the little benefit that is accrued to them.
Rising asset prices
Lower rates of interest will make acquisition of assets such as housing more lucrative. The increased demand will, therefore, push the prices of such assets up.
Depreciating exchange rates
When the FED reduces the interest rates then it will be less promising to save money in the US. This will eventually lead to a slump in the value of the dollar.
Cheaper borrowing costs
When the interest rates are low then commercial banks dispense loans at cheaper rates. This encourages investors to take up loans to finance expansion projects.