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Chapter 21, Part II. The Power of Interest Rates. Page 3

Discussion in 'Complete Trading Education- Forex Military School' started by Sive Morten, Dec 22, 2013.

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  1. Sive Morten

    Sive Morten Special Consultant to the FPA

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    Pipruit: Cool! And what we have to do then?​

    Commander in Pips: Well, the Central Bank starts gradually to increase interest rates to chill out an overheated economy. The rate of return of companies (profit margin) on borrowed money gradually becomes less (or even negative) due to growth in interest rates, since their interest expenses become bigger. And to continue investment in growth of company becomes less attractive. It becomes more expensive to borrow more money, so the pace of growth is reduced as is the growth of prices on raw materials and final products. Since rates become high, it’s become more attractive to lend money than to borrow it. To reduce inflation, the Central Bank need to reduce money amount in turnover. Since te Central Bank makes high rates – money start to flow to the Central Bank, because banks buy bonds, the public open deposits, companies stop to borrow etc. So the amount of money in turnover gradually is reduced as is inflation. But it can leads to a chilling and stagnation in the economy – demand for commodities is reduced, industrial production decreases, revenues of companies are reduced also.


    Pipruit: So now the Central Bank needs to decrease rates again. Otherwise, there will be a recession…​


    Commander in Pips: Ok, you see it already. Right. Then the Central Bank starts to decrease interest rates, and all that stuff repeats again. This makes economy moves with cycles.


    Pipruit: But why can’t a Central Bank find some equilibrium – such rates that will allow the economy to grow and to not overheat.​


    Commander in Pips: This happens because a nation’s economy is a big thing, you know…between Central Bank action and the real effect on economy some time passes. So, a Central Bank will see how it impact on economy after some months have passed. So, they will be able to assess their action only after some time. So if the Central bank has overreacted a bit or under-reacted, this will make the economy fluctuate. To neutralize those fluctuations a Central Bank needs to make the opposite action with interest rates. Now imagine how difficult (or even impossible) it is to reach equilibrium, taking into account the time lags between the Central Bank’s action and market reaction to them.


    Pipruit: I see…

    Commander in Pips: So, let’s introduce it with some scheme:


    [​IMG]


    Pipruit: Ok, I’ve got that, but what is an application to forex market?​
     
    #1 Sive Morten, Dec 22, 2013
    Lasted edited by : Sep 24, 2016
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