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Economic Misconception

The world is full of muppets who aspire to puppet movements. In other words, others control the outcome by pulling the strings up and down or from side to side, as they feel fit.

According to “The UK Times” increasing the bank rate is like a lever for slowing down inflation. By raising it, people should, in theory, start to save more, which will push down demand for goods and services and lead to lower prices.

However, pushing down demand for goods would mean less production, or if firms adhered to reducing prices to increase possible demand, then sales productivity would potentially be maintained while less profit margin achieved, hence theories are all well and good, but in the end one economic concept could create other jeopardies.

One example of this scenario is if interest rates increase across the board, home owners who could already be stretching their financial resources to the limit would be penalized even more, and therefore could find themselves without sufficient funds to meet the monthly payments.

A good example of this is the housing bubble in the 2000s whereby there was the impetus for the subprime mortgage crisis. The public got behind on their payments, homes were repossessed, and consequently money markets were affected. Housing prices peaked in early 2006, started to decline in 2006 and 2007, and reached new lows in 2011.

According to research, raising interest rates helps to reduce the overall level of demand and therefore, hopefully, reduces the upward pressure on prices. So why might this cause a recession, one might ask? Well in the long run, businesses may respond to consumers purchasing fewer goods and services by reducing production, thus causing dire circumstances.

If there is reduced production then employees might be laid off, less sales would equate to firms’ profits dropping and quintessentially more overall problems, less governmental taxes collected, and then potential bankruptcy that goes along with reduced turnover and more debt.

Brazil’s Central Bank’s current interest rate index, 13.75%, is at its highest since January 2017 and one of the highest in the world. It was frozen in August 2022, after a cycle of increases that started in March 2021, when it reached a record low of 2% to stimulate the economy, amid the covid-19 pandemic.

In the United Kingdom, the bank rate is the interest rate set by the Bank of England. It currently stands at 4.25% after the Bank increased it from 4% in March 2023. That’s the eleventh rise since December 2021 when the rate was at 0.1%.

Often banks borrow funds from the central bank. When a commercial bank gives back what it borrowed, it has to pay an interest rate. The central bank has the power to set its own interest rates, which effectively determines the price of money.

These are the benchmark rates that central banks are currently raising to tame inflation. The logic is based on a cascading effect (domino): if central banks charge higher rates to commercial banks, commercial banks in turn increase the rates they offer to households and businesses who wish to borrow.

As a result, personal debt, car loans, credit cards and mortgages turn costlier and people become more reluctant to request them.

Companies that regularly ask for credits to make investments begin to think twice before making a move. Meanwhile, governments are forced to make higher payments for their national debt.

Tighter financial conditions inevitably lead to a fall in consumer spending across most or all economic sectors.

Fundamental economic rules show that when demand for goods and services decline, prices follow suit. This is exactly what central banks intend to do at present: curb spending to curb inflation.

But the effects of monetary policy can take up to two years to materialise and are therefore unlikely to offer an immediate solution to the most pressing challenges.

Complicating matters is the fact that energy is currently the main driver behind inflation, fueled by a factor totally unrelated to the economy: Russia's unprovoked invasion of Ukraine.

Electricity and gasoline are commodities that most people use regardless of how much they cost, so a quick and drastic drop in demand to cool prices cannot be taken for granted.

This explains why central banks are taking such radical steps, even if it ends up hurting the economy. Aggressive monetary policy is a tightrope walk: making money more expensive can slow down growth, weaken salaries and foster unemployment.

No one knows whether this process will lead to a recession or, if so, how significant that recession will be.

Have a great day!

Prof. Carl Boniface

Vocabulary builder:

Muppets (n) = a trademarked name, refers to puppets descended from Jim's originals that are created for Sesame Workshop and appear on Sesame Street or are owned by The Walt Disney Company. Jim Henson's Muppets were built in a wide range of techniques that are still used today. The classic example is Kermit the Frog.

Jeopardies (n) = dangers, risks, threats, perils, hazards, difficulties, troubles

Dire (adj) = terrible, awful, dreadful, horrible, dismal, grim, disastrous

Quintessentially (adv) = typically, essentially, characteristically, ideally, in essence, (ant) atypically

Turnover (n) = income, revenue, business, incomings, gross revenue, takings, trade i.e., 1. the amount of money taken by a business in a particular period. "The turnover is approaching $4 million." (syn) gross revenue, yield, volume of business, sales. 2. the rate at which employees leave a workforce and are replaced. "High staff turnover left the program with too many young instructors."

Subprime (adj) referring to credit or loan arrangements for borrowers with a poor credit history, typically having unfavorable conditions such as high interest rates.

Tame (adj) = pacified, disciplined, cultivated, domesticated. “The horse was wild, so they needed to tame it into a fine show horse.”

Cascading effect = the domino effect is an example of a cascade, and these cascades can get out of hand surprisingly quickly. A few little dominos falling in the wrong places, and you have a catastrophe on your hands. We've had several names for cascades like these: the snowball effect, the butterfly effect, and the domino effect.

Foster (adj) = nurture, raise, adopt, stand-in, substitute, temporary, short-term

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