Question

If an analyst was considering the effects of interest rate on the future direction of the economy, would she focus on the short rate as controlled by the central bank, or long rates as controlled by the market? Why?

Answer 1

As far as the effects of interest rate on the future direction of the economy are concerned, the focus should mainly be on the long term interest rates. This is because the state of the economy depends on the level of demand & supply of goods & services. The supply of goods and services is impacted by the rates at which businesses have access to long term capital rather than short term capital. If long term interest rates are high the cost of capital would be high for businesses (as interest rates affect both debt & equity capital costs). A high cost of capital implies lower investments in businesses which would cause the economy to slow down in the long term.