Changing Interest Rates

Last week I discussed value as it relates to the recent volatility in the stock market. Some commentators have attributed price volatility to recent changes in interest rates. They have gone on to speculate about when the Federal Reserve will “raise interest rates.” I figured now would be a good time to open the subject of why the Federal Reserve — or anyone else — cannot raise interest rates.

The truth of this statement lies in the fact that an interest rate amounts to a dependent variable. No one can change a dependent variable directly. Changing a dependent variable requires changing one or more of the independent variables used to calculate it.

It’s that simple, but I should explain in a bit more detail.

In the details of my explanation I will refer to the diagram below.

First, this diagram shows the number of units of goods on the vertical axis and time on the horizontal axis. The left side of the time axis indicates the amount of current goods provided by one party in exchange. The right side of the time axis indicates the amount of future goods provided by another party in the same exchange.

Second, for the sake of explanation, people divide the future goods into two categories: principal and interest. The principal amounts to the number of units provided as current goods. The interest equals the difference between the total future goods and the amount of principal.

Third, the sloping line between the total current goods and the total future goods represents the rate of change in interest. The slope of that line equals the rate of interest. To be precise, the rate of interest to the quantity of goods exchanged with each unit of time. To state it another way, an interest rate would amount to, for example, five units per year or 10 units per year or, if it were a money transaction, $10 per year.

What people frequently refer to as an interest rate, really consists of a fractional rate of interest. It consists of the rate of change in interest over time as a percent of principal — e.g. five percent per year or 10 percent per year.

Fourth, the only ways in which the rate of interest or the fractional rate of interest can change are to change one or both of: the quantity of current goods or the quantity of future goods.

I have described interest in terms of goods, rather than dollars, because interest can be paid in any good in addition to money. This distinction becomes important when we take into consideration that money simply acts as a medium of indirect exchange.

Thus, the Federal Reserve can only influence rates by engaging in transactions that influence the amount of current dollars available or the amount of future dollars (usually in the form of government bonds) available. Clearly understanding how the Federal Reserve goes about influencing interest rates will help you more clearly understand the impact and limitations of this influence.

I will return to this point in future posts, because more examples will make this very important concept clearer.

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