South-Western College Publishing - Economics  
Wealth and Worry
Subject Interest Rates
Topic Monetary Policy
Key Words Interest Rates, Aggregate Consumption, Inflation, Economic Growth
News Story

The impact of an increase in interest rates on aggregate consumption is negative. Consumers generally reduce their purchases of durable goods, like automobiles and homes, which are generally financed over time. For more and more individuals, rising interest rates can affect their consumption through change in their wealth.

The Federal Reserve has raised interest rates twice this year and many investors believe it is likely that it will increase rates again. As rates rise, stocks become less attractive investments, since the rate of return on bonds rises and is relatively safe. As stocks become less attractive, individuals want less of them and stock prices may fall. This fear of interest rate increases is especially strong in high-technology companies whose prices have soared in recent years.

Interest rates started to increase even before the Federal Reserve approved two quarter-point increases in June and August. These rate increases were the result of an increase in the demand for investment capital stemming from the recovery of the Asian economies. The continued strong economic growth in the U.S. was also a contributing factor, as concern about inflation increased. The yield on 30-year Treasury bonds increased to 6.26 percent recently, a 26 percent rise from December's rate of 4.96 percent. Other interest rates have followed. The rate on a 30-year fixed mortgage is now about 7.8 percent, an increase of a full percentage point since last year.

The economic boom of the last few years has been consumer driven, aided by the tremendous increase in wealth resulting from the increase in the price of stocks. If interest rates rise and stock prices weaken, the wealth effect can cause consumers to cut their consumption and sell their stocks.

(Updated December 1, 1999)

Questions
1. Explain why, or under what circumstances, the Federal Reserve would want to increase interest rates.
2. Using a demand and supply diagram for money, explain how the interest rate is determined.
3. How can the Federal Reserve bring about a change in the interest rate?
Source George Hagar, "Investors Start Taking Stock of Their Fears", The Washington Post, October 16, 1999.

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