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Question:

Choose One of the US or the Eurozone and Evaluate the likely Future path of Interest Rates Over the next 2 years.
 
 

Answer:

Future projection path of interest rates in United States in the next two years

Interest rate of a country corresponds to the rate that is charged by the central bank from the commercial banks   of the country (Li and Hazari 2015). United States is considered as well developed nation of the world, which is considered as the world’s largest economy by nominal GDP. With a population of only 4.3% of the world, the nation is capable of maintaining a strong economical background of country.

This essay aims at focussing on the trends of interest rates of the nation. Being one of the developed nations of the world, the focus of the essay is to attain a projected path of the country’s interest rate trends for the upcoming two years. The essay states the past twenty year trends of the interest rates in United States, which would be quite helpful in acknowledging and predicting the future trends of the mentioned macroeconomic variables. The factors that influence the inflation rate of the country has been taken into consideration thereby predicting the projected path in the end.

Interest rates considered as the profit over time due to the financial instruments of a country. Interest rate is noted on the annual basis, which is calculated based on annual percentage rate. In the ISLM model, the lm curve  deals with the combination of output (Y) and interest rate (r). these two variables equilibrate the money market, thereby giving the country’s nominal money supply level M and price level P. The LM curve deals with the combination of all Y and r, which would ascertain the equilibrium in the money market of the economy. According to Mankiw (2014), the equilibrium condition, the real money demand of the country must be equivalent to its real money supply. Hence, the equilibrium condition must be stated by :

Md(Y,r) = M/P

In the above-mentioned equilibrium condition, the equation on the right side denoting the real money supply is fixed. This states that any change in the real money supply, shifts the entire LM curve. Based on the assumption of real money supply being positively related to the output, Y and negatively related to interest rate, r, the LM curve is upward sloping in nature (Beeghley 2015). In an economy, with the shifts of the lm curve, there is a considerable alter in the rate of interest prevailing in the economy.

 


The changes of the interest rates structure are dependent upon both the internal and the external influence of the financial markets of the country. The economic performance of the country along with its perspective and expectations of the potential loan receivers as well as the overall country is quite vital in affecting the changes of the interest rates (Gopinath, Helpman and Rogoff 2014). The interest rates of a country are dependent upon the agreements of the institutions of the economy. Central bank policy is considered as one of the most important factor prevailing in the economy, which helps in laying an emphasis on the interest rates of the country. Depending upon the rise in the money offered by the central bank to the commercial banks in a country, determines the interest rate that may be directly affecting the contracts to be made in these banks.  

In order to predict the future projection path of the interest rate trends in a country, the most important factor that needs to be taken into consideration is the monetary policy of the country. In an economy, monetary policy helps in anchoring the rate of inflation of a country around the targeted inflation rate of the country. The central bank of the economy, aims at attaining a stable inflation rate of the country that would thereby help in maintaining a sustained interest rate level (Schwartz 2014).  On attaining a sustained inflation rate of the economy, the inflation gap and the output gap should be quite proportional to each other. The changes in the interest rates of the country should be gradual in nature. This would help in acknowledging the effects of the interest rates and the economical developments of the country. These indications are efficient enough to denote that the interest rate of the country would be quite well maintained and appropriate in nature.

The trend of interest rate in United States for the past twenty years is quite fluctuating in nature. The interest rate had faced a considerable drop fro, the year 2000 to 2004. A steep rise in the interest rates has been visible in the next three years. During the time of financial crisis in the period of 2007-2009, there is a steep fall in the rate of interest of the country from 5.25 in 2007 to 2.47 in 2009. Since, 2011, a stability in the gradual increase in the interest rate of the economy has been seen until the year 2014. A sudden rise in the interest rate has been noticed in the economy in the year 2015 from 1.43 to 2.16 (Data.worldbank.org 2017).

Figure 1: Past interest rate trends of United States from 1995-2015

(Source: Data.worldbank.org. 2017)

           

It is known that rate of interest is the amount charged, which is expressed as the percentage of principal. As per the statement of Galí (2015), it can be mentioned that interest rates are considered as the rate of annual basis and it is known as annual percentage rate. Therefore, interest rate is known as the cost borrowing money. In order to forecast the future trend of interest rate of United States, it is necessary to determine the price level of the goods across the economy. It is known that there is a positive relationship between the price level or inflation rate and interest rate. Therefore, it is necessary to highlight the future trend of inflation rate of United States in order to identify the future trend of interest rate of the economy, which would be discussed in the following:

2018

2.37 percent

2019

2.49 percent

Table 1: Future year’s inflation rate

(Source: Created by author)


Figure 2: Projected annual rate of inflation in United States

(Source: Laubach and Williams 2016)

From the above table and above figure, it can be observed that the future trend of United States will be increased. Therefore, it can be inferred that the rate of interest will also be increased in the future two years. According to Barsky, Justiniano and Melosi (2014), rise in the rate of inflation reflects the increase in the price level of the goods. Therefore, the purchasing power of the country will be increased.

On the other hand, it can be added that increase in the price level will decrease the real money supply. Therefore, the demand for money exceeds the money supply and the real interest rate is lower compared to the new equilibrium interest rate.

The annual interest rate will increase from 0.5 percent to 0.75 percent in 2018. Therefore, the labour market will strengthen and the economic activities will be improved. The unemployment rate will be at steady position. As a result, it can be predicted that the job growth will be continued with the slower improvement of household spending. In this purpose, it can be stated that the rate of interest will be increased after the presidential election of Donald Trump. Due to the prospect of higher rate of inflation and higher deficit, it can be mentioned that this will be spurred by the taxation policy as well as the spending proposal of Donald Trump. In addition, Kuttner and Shim (2016) pointed that the Federal Reserve will also be increased at the short-term rates twice within the year. The Fed wants to increase the rate gradually in order to dampening the growth of the economy. In this connection, it can be expected that the preferred level of 3 percent in the short term rate until the year of 2020. On the other hand, the Fed reflected the improvements in customer and the business sentiment and also predicted to increase the rate up to 2.0 percent. Therefore, monetary policy of the country will be adjusted.

Interest rates are considered an important macroeconomic variable of a country that helps in determining the stability of the country. Interest rates of the country are determined by the money equilibrium market, which helps in sustaining the macroeconomic conditions of the economy. In this essay, the future trend of the interest rates of United States has been taken into consideration. The past trends of the rate of interest and the monetary policy prevailing in the economy, it could be concluded that there would be a rise in the interest rate in the upcoming two years. There would be an increase in the price level of the economy thereby positively affecting the inflation rate. Hence, an upward pressure on the interest rate of the country would be visible.

 

References

Barsky, R., Justiniano, A. and Melosi, L., 2014. The natural rate of interest and its usefulness for monetary policy. The American Economic Review, 104(5), pp.37-43.

Beeghley, L., 2015. Structure of social stratification in the United States. Routledge.

Data.worldbank.org. (2017). United States | Data. [online] Available at: https://data.worldbank.org/country/united-states [Accessed 24 Feb. 2017].

Galí, J., 2015. Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

Gopinath, G., Helpman, E. and Rogoff, K. eds., 2014. Handbook of international economics (Vol. 4). Elsevier.

Kuttner, K.N. and Shim, I., 2016. Can non-interest rate policies stabilize housing markets? Evidence from a panel of 57 economies. Journal of Financial Stability, 26, pp.31-44.

Laubach, T. and Williams, J.C., 2016. Measuring the natural rate of interest redux. Business Economics, 51(2), pp.57-67.

Li, K.W. and Hazari, B.R., 2015. The possible tragedy of quantitative easing: An IS-LM approach.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Schwartz, A.F., 2014. Housing policy in the United States. Routledge.

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