- Joined
- Jun 28, 2020
- Messages
- 6,618
- Reaction score
- 715
- Points
- 212
- Awards
- 2
Supply and Demand
Market interest rates are determined by the supply and demand for loanable funds. Businesses demand credit to finance new investments and ongoing operations. Consumers also demand credit for new purchases and to finance their expenses against their income on a revolving basis. These funds can be provided out of household savings or new credit created by banks. The market for loanable funds behaves in many ways similar to any other market where changes in supply and demand change the price—in this case, the interest rate.
Credit Crunch
The onset of a recession is usually marked by a credit crunch—an increase in demand for borrowing but a decrease in willingness to lend.
At the onset of a recession, there is an increase in demand for liquidity—usually across the board. Businesses rely on credit to cover their operations in the face of falling sales, consumers run up credit cards or other sources of credit to make up for the loss of income. There's a decrease in supply at the same time, as banks curtail lending. They do this to increase reserves as a way to cover losses on loan defaults and as households draw down savings to cover living expenses when their jobs and other income dry up.
Just like any good in a market, when demand increases and supply decreases, prices rise sharply. So the normal expectation would be for interest rates to rise as the recession begins.
Role of the Central Bank
A central bank, such as the U.S. Federal Reserve, has the ability to influence interest rates by buying and selling debt instruments and increasing or decreasing the supply of credit in the economy. During a recession, the Fed usually tries to coax rates downward to bail out borrowers—especially banks—and stimulate the economy by increasing the supply of credit available.1
The Fed buys bonds, usually U.S. Treasury bonds or similarly high quality, low-risk bonds. In doing so, it injects an equivalent quantity of new reserves into the banking system, which supplies banks with fresh liquidity and directly lowers the federal funds rate—the rate at which banks loan each other money to meet immediate liquidity needs. This, in turn, leads to an influx in new lending, which lowers interest rates and supplies businesses and individuals with the loans they need to finance purchases and continue normal operations.1
The federal funds rate—the interest financial institutions pay for overnight borrowing—has a direct impact on the prime rate, which is the interest rate that banks charge their best customers.
The end result is that the central bank’s expansion of the supply of credit counteracts the market forces of supply and demand, and interest rates for businesses and consumers fall during the recession. Although the newly created credit extends a lifeline to debt-dependent businesses and borrowers, it has other effects as well.
Monetary Policy, Interest Rates, and the Real Economy
Central bank monetary policy is an attempt to do an end-run around supply and demand, but as with other government policies, it comes with unintended consequences.
Firstly, the lower market interest rates discourage saving, hurting savers who now receive a lower return in exchange for forgoing their own consumption for the present. Secondly, because this means that less saving occurs, the resale resources that saving frees up for investment under normal conditions don’t materialize.
The central bank’s newly created credit encourages both businesses to use more resources in their investment projects and consumers to simultaneously consume more resources. In the long run, this can cause additional problems in the economy such as inflation. It could even sow the seeds for a future recession.
Special Considerations
Policymakers often take steps to support the economy and promote growth during times of crisis. These steps help prevent economic slowdowns and recessions from taking place. For instance, the Fed announced plans to provide support to individual consumers and businesses in order to support the economy after the global COVID-19 pandemic hit.
The Fed laid out several key plans in order to keep the flow of credit going in the market. Among these actions are:
The purchase of Treasury securities and mortgage-backed securities (MBSs) to support market functioning
New financing to the tune of $300 billion to provide more credit to consumers, businesses, and employers
Creating two credit facilities for large employers—the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility
Establishing the Term Asset-Backed Securities Loan Facility, a third credit facility, to help credit flow to businesses and consumers2
In order to keep its targets for maximum employment and inflation rate at 2% over the long-run, the Fed decided that the target range for the federal funds rate would remain between 0% to 0.25%.3 As of November 2020, rates would remain within this range until suitable labor market conditions. The Federal Open Market Committee (FOMC) said it will monitor trends and information and their impact on
Market interest rates are determined by the supply and demand for loanable funds. Businesses demand credit to finance new investments and ongoing operations. Consumers also demand credit for new purchases and to finance their expenses against their income on a revolving basis. These funds can be provided out of household savings or new credit created by banks. The market for loanable funds behaves in many ways similar to any other market where changes in supply and demand change the price—in this case, the interest rate.
Credit Crunch
The onset of a recession is usually marked by a credit crunch—an increase in demand for borrowing but a decrease in willingness to lend.
At the onset of a recession, there is an increase in demand for liquidity—usually across the board. Businesses rely on credit to cover their operations in the face of falling sales, consumers run up credit cards or other sources of credit to make up for the loss of income. There's a decrease in supply at the same time, as banks curtail lending. They do this to increase reserves as a way to cover losses on loan defaults and as households draw down savings to cover living expenses when their jobs and other income dry up.
Just like any good in a market, when demand increases and supply decreases, prices rise sharply. So the normal expectation would be for interest rates to rise as the recession begins.
Role of the Central Bank
A central bank, such as the U.S. Federal Reserve, has the ability to influence interest rates by buying and selling debt instruments and increasing or decreasing the supply of credit in the economy. During a recession, the Fed usually tries to coax rates downward to bail out borrowers—especially banks—and stimulate the economy by increasing the supply of credit available.1
The Fed buys bonds, usually U.S. Treasury bonds or similarly high quality, low-risk bonds. In doing so, it injects an equivalent quantity of new reserves into the banking system, which supplies banks with fresh liquidity and directly lowers the federal funds rate—the rate at which banks loan each other money to meet immediate liquidity needs. This, in turn, leads to an influx in new lending, which lowers interest rates and supplies businesses and individuals with the loans they need to finance purchases and continue normal operations.1
The federal funds rate—the interest financial institutions pay for overnight borrowing—has a direct impact on the prime rate, which is the interest rate that banks charge their best customers.
The end result is that the central bank’s expansion of the supply of credit counteracts the market forces of supply and demand, and interest rates for businesses and consumers fall during the recession. Although the newly created credit extends a lifeline to debt-dependent businesses and borrowers, it has other effects as well.
Monetary Policy, Interest Rates, and the Real Economy
Central bank monetary policy is an attempt to do an end-run around supply and demand, but as with other government policies, it comes with unintended consequences.
Firstly, the lower market interest rates discourage saving, hurting savers who now receive a lower return in exchange for forgoing their own consumption for the present. Secondly, because this means that less saving occurs, the resale resources that saving frees up for investment under normal conditions don’t materialize.
The central bank’s newly created credit encourages both businesses to use more resources in their investment projects and consumers to simultaneously consume more resources. In the long run, this can cause additional problems in the economy such as inflation. It could even sow the seeds for a future recession.
Special Considerations
Policymakers often take steps to support the economy and promote growth during times of crisis. These steps help prevent economic slowdowns and recessions from taking place. For instance, the Fed announced plans to provide support to individual consumers and businesses in order to support the economy after the global COVID-19 pandemic hit.
The Fed laid out several key plans in order to keep the flow of credit going in the market. Among these actions are:
The purchase of Treasury securities and mortgage-backed securities (MBSs) to support market functioning
New financing to the tune of $300 billion to provide more credit to consumers, businesses, and employers
Creating two credit facilities for large employers—the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility
Establishing the Term Asset-Backed Securities Loan Facility, a third credit facility, to help credit flow to businesses and consumers2
In order to keep its targets for maximum employment and inflation rate at 2% over the long-run, the Fed decided that the target range for the federal funds rate would remain between 0% to 0.25%.3 As of November 2020, rates would remain within this range until suitable labor market conditions. The Federal Open Market Committee (FOMC) said it will monitor trends and information and their impact on
