Interest Rate is a macroeconomics jargon that I’ve recently came to learn about and I was intrigued at the power that it has to influence economic activity across the globe.

 For consumers, interest rate is defined as the rate of returns for making savings available in the loanable funds market that is essential for financing investments and purchasing of bonds and securities. For speculators and investors, interest rate is essentially the explicit cost of borrowing.

 Interest rates can be determined in the loanable funds market by natural forces of demand and supply, where in this case interest rates refer to the equilibrium value and price at which loanable funds are loaned and borrowed.

Interest rates also act as a monetary tool to adjust the demand side of the equation should the economy be either overheating or stagnating. For large and dominant economies such as the United States, the Federal Reserve, US’s Central Bank, is able to adjust interest rates in favour of achieving marcoeconomic goals. Conventional economic theory states that lowering interest rates will lower the opportunity cost of borrowing for consumers since the rate of returns from savings have decreased. On the other hand, with rate of returns from investments holding an inverse relationship with interest rates holding marginal efficiency of investments constant, investors and speculators will see an increase in profitability of investments. Both of which will boost aggregate demand and accelerate the country’s real national output growth. Interest rates seem to be a suitable tool for stimulating demand and hence growth in the economy.  The converse holds true as well, where the Central Banks use interest rates as an inflation fighter and to cool down the overheating economy.

Yet, policy makers would find that as much as monetary policies is able to bring an economy out of a recession in theory, orthodoxy monetary policies hardly work during recessions because the situation is not as rosy as it seems to be. John Maynard Keynes proposed that the level of investments is rather interest-inelastic and is mainly affected by factors such as level of confidence in the economy and based on instincts of investors. Also, a more pertinent issue here is that in the aftermath of a financial crisis, banks are often unwilling to lend as they require more credit worthiness than usual in consumers and investors. Consumers, on the other hand, are more concerned with reducing their liabilities by increasing savings and it is unlikely that they will borrow in the short run.

With interest rates near zero, Central banks run into risks of falling into a liquidity trap, a phenomenon where adjusting interest rates will no longer affect consumption and investments and when monetary policy fails totally.

Other than the domestic economy, interest rates will also exert an effect on the external economy of the country. With the rise of interest rates, the financial account will see a net financial inflow of funds and capitals as investors and speculators deposit their assets here in order to make short term profits on interest rate differences (See also: Hot Money). In the Foreign Exchange Market, this will essentially boost demand for domestic currency. Assuming that the supply of domestic currency in the Forex market remains constant, the surplus of demand over supply of domestic currency will result in an appreciation of the currency, causing the currency to grow stronger relative to global currencies. The implications of rising interest rates is thus a stronger currency that will enable the country to consume more imported goods and off-setting any cost-push inflation at the cost of its competitiveness in the external sector. The converse holds true as well.

I believe it has been aptly illustrated that interest rates, though simple in function, plays a pivotal role in many economic activities in the Market. It is unbelievable how a simple tool can cause a chain of after-effects that either stabilizes or destabilizes the economy. For Singapore being an open economy that is reliant on international trade flows, she is an interest rate taker. But with that said it doesn’t mean that Singapore is disadvantaged, not least the outcome of using monetary interest rate to combat symptoms of economic ailments is an uncertain one.

Assumptions are everywhere.  As insignificant it may sound, assumptions make up the basis of our way of life. We do not know what the future may present us with, and therefore we choose to assume to confide in ourselves this sense of certainty.

Economists make assumptions too. In the real world, it is almost impossible to have a constant because everything is dynamic. Even in the Market, there will always be variables. Well, perhaps only in the extreme short run will you find a constant in the Market, such as that of the price of goods & Services or costs of production. Even for the General Price Level (GPL), if you consider macroeconomics, it will be varying in minute percentages, depending on the change in price of the range of goods & services which make up the GPL. The first assumption that comes into mind is undeniably Ceteris Paribus ( Cet. Par.), or holding all other factors constant. This assumption is the most over-used assumption in Economics. Why so? This is because as much as the nature of Economics itself demand such a condition for its models to work, it is often an unrealistic one if you consider the context of the question in the real world. The question here is, will all other factors remain constant? And if so, how?

Economists actually relate assumptions to a certain type of condition in order for the market to work. Another set of assumptions that you may think of is Elasticity concepts. Firms will lower the price of goods & services charged in order to maximize revenue, assuming that the demand for G&S is price elastic. The converse also holds true. Firms, assuming to be profit maximizers, will increase the price of goods & services to maximize revenue should they assume that the demand for G&S is price inelastic. Firms often have to make such assumptions because in reality, it is often difficult to measure precisely the exact value of PED for the range of products that it produces. Therefore, economists make predictions and assumptions. In a market where barriers of entry and competition exists, firms often have to make assumptions on values of the cross elasticity of demand (XED) to strategize its profit maximizing behavior, whether should it lower or raise its own prices if the firm wants to result an substitution effect? Firms may also make assumptions on the willingness and abilities of consumers to consume a certain good should it practice price discrimination. Again, economists fall back on trends, predictions and assumptions.

 Another assumption that is close to your heart will be the Marshall Lerner Condition. In the macroeconomy, policy makers and economists may tighten monetary interest rate policies in order to effect a net inflow of currency to accelerate its economic growth. Yet, should the Marshall Lerner Condition be absent, such a movement may lead to a worsening of the Balance of Payment position because global transactions are often tied and bound by contracts which result in such currency inflows being inelastic despite increasing interest rates.  This is more aptly captured by the J-curve effect.

Well, I believe that assumptions do provide the fundamental basis that allows many economic models to work. Yet, each assumption is heavily flawed and seldom do economists see the assumptions existing in the real world. However, it is still interesting to include assumptions in your economic train of thought because that is what that allows you to develop your intuitions. Trust me, you’ll find yourself in a glitch should you exclude assumptions because there are simply too many variables in your equation. Often in the conclusion of your essays, you might want to write something that relates to the second part of the question (if you’re doing part A essay) or something that will leave an lasting impression on the examiner. One strategy you can consider is to turn assumptions off, like a switch. When assumptions are turned off, many economists will find themselves having an outcome that is totally different from one with the assumptions. Will you still achieve your goals then?

In the conventional free market structure, market efficiency is said to be achieved when the optimal desired outcome is achieved by the allocation of scarce resources. That leads us to the concept of market efficiency. We can just narrow this concept down to allocative efficiency if we were to exclude the cost of production and only consider the consumption side of the equation. In the conventional model of classical Economics, allocative efficiency is said to be achieved when the market (aggregate summation of all firms and its respective production processes) produces at the quantity of the output where the price charged coincides with the marginal cost of production. This is held to be true based on the Marginalist Principle, where price in this case refers to the marginal benefit of production. And you’ve learnt that firms are assumed to be profit maximizers and they will produce at the quantity of output where MC=MB. (See derivation by calculus) Yet, this model of market efficiency has drawn criticisms from around the world by different renowned economists and Economic Institutions. As opposed to the model, the thesis that was provided is that allocative efficiency, as much as it results in an optimum desired outcome in terms of resource allocation, will not necessarily result in a just and fair consumption by everyone. Now the question is, why? You may ask.

The answer is more or less intuitive: The existence of income inequality.

Even at the allocative efficient price charged by forces of supply and demand, assuming a free market, there is bound to have people who are not able to consume it because they simply can’t afford to. Now, you may ask a very fundamental question, for those people who are willing but unable to consume, shouldn’t they be excluded from the market by the definition of effective demand? From an economist’s point of view, yes. But even if they are economists, they will always find it difficult to do so. This is because in the real world, even economists are guided by their innate sense of morals. It will be immoral to exclude people without purchasing power from the markets as well as the concerns that it brings.

Consider this example, If 2 people in the whole world, 1 being the producer and 1 being the consumer, own all of the wealth in the world and produce and consume at the allocative efficient price and output, there will still be market efficiency because all resources are utilized in such a way that the optimal outcome is achieved. By conventional Economics, this example is allowed, it doesn’t violate, and it fits perfectly.

But you know for sure, it is not an accepted possibility by the world because we simply care for the less fortunate. That is why politicians, economic ethicists bother so much about reducing the income gap. Such economic model is said to have excluded all considerations for humanity, which of course, is an unrealistic one in the real world. In the real world, you’ve to realize that it doesn’t paint a picture as simple as that illustrated by models. Often, there’s a dilemma, a trade off between choosing to achieve one outcome over the other. There’s also the complexity and implication of the picture by human nature.

In Economics, what seems to be harmful may prove to be useful. Let’s take income inequality as an example again. Income inequality provides the basis for capitalism that is essential for the economic progress of less developed countries. Should everyone earn the same wage, with them not being able to match their value of their skills to their wages, there will simply be no motivation for enterprise, or to take risks. That is a reason why communism doesn’t work. Therefore looking at another perspective, income inequality actually provides a different nuance in ensuring the wellbeing of the economy as a whole.

Even in Politics, there is so much gridlock to the game. The market can be driven by the “Invisible Hand” to fulfill the desires of men in the best way possible, or with some prudent intervention. Yet, as one gains, another will lose. This is the irony of allocating resources, the dilemma of the Free Market.

My greatest desire is to play for my audience, the greatest melodies that are intrinsic to Love.

imjustsocrazy:

We are running out of time to be able to be foolish and not bear the full consequences of our actions. As we grow up and mature, we will constantly find the need to consider about so many things. Sometimes we may realise that suddenly there’s so many things that’s holding us back from simply…

Haven’t really got the chance to type down my thoughts and reflections here for a long while. Partly because i was occupied with studies, partly because i was doing some soul searching, and partly because i was looking for inspirations. 

Many great people out there lament on the thought of studying, not to even think about going through simulated examinations. For me it was mentally exhausting and of course, there are times where i fall short of my own expectations, times when i feel so inferior to the others. Let’s just say this is part and parcel of life and growing up, nothing’s easy if you want to be really good at it. For many high achievers out there, it may seem as though they are leading a perfect life, but have you ever thought that it’s just that we can’t see the sacrifices that they’ve made behind the scenes? I always believe that life is fair to everybody. There will be a place for each and everyone because all of us are here for one reason. And what this reason is, is for you to use the whole of your life, perhaps, to figure out.

Sometimes my peers ask me where do i get my drive and motivation from. I wouldn’t say that it’s a drive. But more of a sense of satisfaction to be more apt. I feel at ease when i am able to achieve what vision i have in mind, because that defines my worth and it gives me confidence. 

At this point in time there are still many things about life which i do not understand. Some of which i have experienced, some of which i haven’t been legal to experience yet. There’s this feeling of uncertainty and emptiness. 

What next?

I realized that there are some things that I can’t let go. It’s okay, I’ll live with it. My fear is my motivation.