It is a well known that interest rates have a commensurable power to influence the economy as a vital tool of monetary policy that is used to control variables like investment, inflation, price stability and unemployment. Generally speaking, the interest rate is described as the cost of using money. We will try to understand what the interest rate precisely is and what determines the prime rate. Then, we will focus on the means to influence the levels in a given an economic situation by the Fed. Finally, we will prove these different possible variations with the help of historical examples. The interest rate is the price that is usually expressed in percentage over a period of time. In simple terms, it is the price that someone pays for the temporary use of someone else's funds (Federal Reserve Bank of New York, 2002). In a way, Interest is the compensation that someone receives for temporarily giving up the ability to spend money or the use of money for a period of time. Let's clarify it with the equation of the simple interest rate (calculated on the original price).
[...] We can determine what influence the level of the interest rate that affects directly consumers, the prime rate. As we said earlier the bank uses the prime rate to determine the majority of the different rates the offer to their customer for loans, credit card Consumers know that the interest rate for a credit card is higher that the one for a car loan. What is the reason? An equation helps us to determine clearly theses different factors that influence interest rates. ( IP+ DRP+ LP+ MRP K = Nominal interest rate. [...]
[...] Retrieved February from http://www.federalreserve.gov/boarddocs/hh/2006/february/testimony.htm Brigham & Houston. (2004). Fundamentals of financial management. Thomson South- Western. [...]
[...] Both the FFR and the discount rate level (decided by the Fed) set variations on the Prime Rate. A higher (smaller) FFR and discount rate increase (decrease) the Prime Rate. The consequences are a reduction of the consumption and the inflation. It has been proved historically that this increase (decrease) is made during expansion (recession) period to contract (stimulate) the economy. Nowadays, The Fed is increasing the FFR (rate is since March 27, 2006) considering that the economy has to be slow down. [...]
[...] Interest rates Generally speaking the interest rate is described as the cost of using money. It is also well known that interest rates have a commensurable power to influence the economy as a vital tool of monetary policy that is used to control variables like investment, inflation, price stability and unemployment. We will in a first time try to understand what precisely the interest rate is and what determine the prime rate. Then, we will focus on the means to influence is level given an economic situation by the Fed. [...]
[...] Then, those variation influence the prime rate (Effectively, if the discount rate and/or that is higher, it cost more money to the bank to borrow, they charge you more by the prime rate). Their decisions to act depend on the economic situation. Effectively, given the economic situation, the Fed will decide to increase or decrease the discount rate. The Open market operations consist of using the power to buy or sell treasury securities (The Fed sell securities when they need to borrow money to finance their deficit). [...]
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