This is a slightly longer topic. Instead of one very long thread (ppl r complaining ) I will break it into multiple bite sized small threads. This is Thread 1 of #interestrates under one trick pony.

This explains how changes in interest rates transmit throughout the economy.

Consider an economy as assumed in Econ101 textbooks where everyone is rational and borrows ie firms as well as individuals. Individuals borrow from banks to buy a house. Firms borrow from banks to buy land, build houses, build furniture and fixtures for individuals.

Demand for housing increases faster than the firms can build, thus house prices increase of new as well as existing. People who live in existing houses feel richer and borrow against equity or line of credit etc to renovate, conspicuously consume or splurge on vacations.

Firms expand by borrowing more to expand production capacity, hiring more people and paying higher salaries to cater to increased demand.

Rising salaries induce people to demand bigger houses, resulting in increase in further increase in house prices and the cycle continues.

Due to this continuous increase in demand and prices, inflation (known as “demand pull inflation”) shoots through the sky. Central bank (CB) steps in by raising interest rates significantly. Suddenly, the interest people were paying on their mortgages and loans goes up.

Their disposable income after paying interest goes down. They reduce their spending on goods and consequently demand for goods and services decreases. This is called “income effect” of interest rates. Firms that buil houses and sell vacations drop prices to keep selling.

Their revenue drops. To cut costs, firms reduce operations, pay down high interest loans and fire employees. Thus the demand for goods/services demanded by firms and ppl goes down. As price of new houses is reduced by firms to sell, price of old houses that ppl live in fall too

They well less wealthy. People feel poorer and reduce spending. This is known as “wealth effect”. Future profitability of firms selling goods, houses, services is expected to go down and stock markets fall. Increase in prices of goods/services stop or increase at a lesser rate.

Rate of inflation falls down.

Thus in this way, CBs reduce “demand pull inflation” by increasing interest rates as per economic textbooks.

Bringing down inflation by increasing interest rates led to job losses and decrease in growth as shown above.

To prevent CBs going bonkers with pony like single minded focus to bring down inflation by raising interest rates and leading to massive unemployment and economic shutdown, government may ask CBs to strike a balance between inflation fighting and maintaining growth/employment.

This may be deemed as “dual mandate” of CB. CB has two mandates that are at tension with each other 1. Inflation control and 2. Maximum employment or growth etc

This brings the background thread to a close. Please read further for a rant

Economists have physical and maths envy. They believe that as physics and mathematical models give perfect predictions, so should their economic models. But economic models deal with ever changing population with changing tastes and irrational behaviours like greed and fear.

In addition, economic policy affects everyone of us. Don’t let economists and their fanboys impress you with their research papers, partial differential equations, DSGE models, jargon, pedigrees to not explain to you how the decision will transmit through the economy.

As my past few threads have shown that how one CB (I won’t name it) headed by imported pedigreed economists who have written papers on monetary policy is totally clueless on how real economy works/is working. Even got the PM to tweet praise for his behind the curve policy.

Also economic decision making is always political. Trade offs economic policy makers make affect everyone. You may not be able to get them to change their decisions but always ask questions and use your grey cells.

Till next thread, cheers.