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Interest Rates: Why is it so important ?

Interest rates or coupons attached to a fixed debt is a significant component to ensure a rewarding portfolio. But the market interest rate has now been manipulated, as can be seen from psychological terms noted below. 

Interest rates are determined by the subjective decision of individuals to spend money now or in the future. In other words, interest rates are determined by the preference of borrowers and lenders. The market forces help in creating a natural Interest rate regime. 

Typically, the higher (or lower) the interest rate is, the more (or less) people will save. Likewise, the higher (or lower) the interest rate is, the smaller (or greater) will be investment. Because investment rather than savings is seen nowadays as being conducive for growth, the lowering of the interest rate is perceived as advancing economic prosperity.

The artificial lowering of the market interest rate induces additional investment. At the same time, savings decline and consumption increases. As a result, the economy starts living beyond its means. The boom is economically unsustainable because the policy-induced deviation of the market interest rate from the neutral interest rate causes malinvestment.

In today's fiat-money regime, money is produced through bank circulation credit: when they lend to private households, firms, and public-sector entities, banks increase the money supply. Money creation through bank circulation credit is onone hand money creation out of thin air- a rise in the money supply that is not backed by real savings while on the other hand, bank circulation credit wreaks havoc with the essential function of the interest rate.

The rise in bank circulation credit necessarily lowers the market interest rate to below the natural interest rate. The natural interest rate is the interest rate that would prevail had there been no expansion of bank circulation credit.

Discrepancy between the market interest rate and the natural interest rate sets into motion the boom-bust cycle in an unhampered market. The market interest rate (adjusted for risk and inflation premiums) is expressive of peoples' time preference, and it corresponds with the natural interest rate. It allows for people allocating current income to consumption, savings, and investment in accordance with their true preferences.

This downward manipulation of the interest rate provokes an economically unsustainable boom, which must be followed by bust.

Note: This blog has been inspired from previous International publication.

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