Good Effects Of Fed Raising Interest Rates Research Paper Example
Effects of increase in interest rates on consumer financing for big tickets
Increased rates of interests have effects on consumer spending decisions regarding the big tickets items such as the automobiles. When the rates of interests are high, there is an overall increase in demand for goods and services. For the case of automobile industry, it signifies that consumers have a relatively increased demand for cars. Due to the excess demand for the cars, the supply fails to meet the demand. Consequently, the prices of the cars go up (Lieberman, 2013). The problem associated with this is that excess demand in addition to increased interest rates is an indicator of an economy that is growing very fast. On the contrary, it can result in an intense economic downward spiral. To prevent this, the Federal Reserve can adjust the rates of interest with the intention of discouraging borrowing. The adjusted rates of interests imply that borrowing money for automobiles becomes expensive. It in turn reduces demand relieving some upward pressure on cars. The increased rate of interest leads to a depreciation in the value of the dollar.
It, therefore, means that consumer’s purchasing power decreases. The implication of this is that consumers will have to pay more for a car in times of increased rates of interests. In case of reduced rates of interests, they would pay less for the same car. The reduction in consumer purchasing power results in a reduction in the auto industry. As a result, the manufacturers in the auto reduce their production so as to reduce their supply of cars in the economy. In the auto industry, equilibrium in the market implies that the adjustments in the rates of interests achieve the goal of stabilization. It must also attain equilibrium amid the demand and supply of cars (Lieberman, 2013). In case the demand for cars decreases a lot, the Fed could consider reducing the rates of interest so as to increases demand.For instance, the price of a new car is approximately $31, 250 with the interest rate of 5%. If the rate increases to 10%, the price becomes $34,375 thus reducing the purchasing power of the consumers.Effects of increasing interest rates on the present and future values of annuities
Annuities are sequences of permanent payments paid to someone or required from someone at a particular rate of recurrence in a fixed period. The types of annuities are the annuity due and the ordinary annuity (Lieberman, 2013). When investors make a purchase of an annuity in time of high rates of interest, they receive higher payments. The brokers and the insurers make extra money by investing the money. It, therefore, implies that high rates of interests lead to improvement in the sales of annuities.
For example, for a case of the present annuity, let the current cash flow be $1000, the rate of interest be 5%, and the number of payments is 5. The present value of the annuity will bePV =C [1-(1+i)-n]/I C= Cash flow, i=interest rate, n= number of payments
Interest rate of 10%PV is $1000[1-(1+0.1)-5]]/0.1=$6209.2The value is greater in the higher interest rate than the lower. The future value of annuities isFv=C [(1+i)-5-1x (1+i)]/i1000[(1+0.05)-5-1] x (1+0.05)/0.05=$5801.91Similarly for higher interest rate of 10%, the present value is $6903.1 Therefore, higher rates of interests lead to improved sales of annuities. Many of the experts opt for waiting until there is an increase in the rates of interests so as to make purchases of the annuities and lock increased payments. Increased rates of interests make the brokers promote variable deferred annuities. There is the support of the annuities by the separate owners that protect them from inflation (Lieberman, 2013). Those individuals with fixed annuities that consist of set interest rates fail to adjust to the market. Their reaction to increased rates of interest involves surrendering the contracts they have. Fixed incomes offer protection against some losses and can hinder investors from making the purchase of products with higher yields.
Effects of increase in rates of interest in NPV calculations
The net present value is an expression of the value of a series of future cash flows in today’s dollar. There are sometimes when the people require an inducement so as to produce some money today and receive it at a future date (Lieberman, 2013). A higher rate of discount rate leads to a reduction in the net present value. Many of the businesses makes use of the net present value in deciding the projects to invest.For example, the present value of $900 for three years and interest rate of 10%PV =FV/ (1+r) nPV=$900/ (1+0.1)3=676.2The present value of the same amount at an interest rate of 15% isPV=$900/ (1+0.15)3=$592.1It implies that higher interest rates lead to lower NPV value. Investors will take projects with higher net present value.
Effects of increase in interest rates on WACC
The weighted average cost of capital (WACC) includes the average after-tax cost of a company’s several sources of capital (Kapoor, 2010). They include the common stock, the bonds, the preferred stock and the long-term debt. Its calculation involves multiplication of each source of capital with its equivalent weight and finally summing up of the products to determine the WACC.In order to calculate the WACC, it’s important to decide the percentage of the finance from the equity and also from the debts. For instance let company A OPERATE with 70 percent equity and 30 percent bonds. 70 and 30 are the weights .let the borrowing rate is 5% per annum. The WACC will be (0.3x0.05) + (0.7x0.06) =5.7 percent. In case of a higher rate of interest of 10%, the EACC will be, (0.3x0.1) + (0.7x1.1) =8 percent. It implies that higher tax rates increase the debts of the company. Increasing the rates of taxes, therefore, discourages the companies from borrowing that may have negative effects on the economy growth.
Effects of increasing interest rates on corporate earnings
Increasing the interest rates reduces the corporate profits. For instance, the federal funds rate in addition to banks pay on overnight loans was around 4.5 percent in 2007. There was the sharp reduction as currently it is almost zero (Gwartney, 2009). The long term rates kept an eye on and fell to not less than 5 percent. There was a record that the reduction in the rates of interests in addition to corporate tax increased the benefits with approximately $30 a share to S&P 500 operating earnings. The interest paid by the United States business was highest at $2.83 trillion marking drastic fall from there to $1.34 trillion in 2011 due to increased rates of interest. Lesser rates of interest explain nearly 40% of the over-all proceeds exclusive of investments from the lower hire and rent costs owing to small rates of interest. For example, let a corporate profit before tax be $320 million. Taking the corporate tax as 10%, the corporate gets $288 million. Increasing the rate to 15%, the corporate gets $272 million. Therefore increase in tax rates lowers the corporate profits.
Gwartney, J. D. (2009). Macroeconomics: Private and public choice. Mason, OH: South-Western Cengage Learning.
Hall, R. E., & Lieberman, M. (2013). Economics: Principles & applications. Australia: South-Western Cengage Learning.
Pride, W. M., Hughes, R. J., & Kapoor, J. R. (2010). Business. Australia: South-Western/Cengage Learning.