Introduction
The nominal interest rate is the real interest rate combined with the expected inflation rate. The definition of the ‘opportunity cost’ in nominal interest can be interpreted as the choice between alternatives of either holding the money, which provides payment protection but forgoes the alternative of gaining interest on another asset, which would be using the money.
Interest rates are cut during recessions as it is one of the most proven and effective short-term monetary tools to stimulate the economy. Lower rates encourage borrowing and investment, by both businesses and consumers. With the availability of cash flow, individuals tend to spend more, creating vital economic activity that can mitigate or reverse effects of a recession.
When the economy is in the state of a recession as it is currently, I tend to spend less and save more due to factors such as potentially smaller flow of income and a lack of assurance that there will be a reliable income in the future. For me, priority spending (food, rent, bills) come first, alongside with a percentage of income I try to save every month. Only then do I spend extra. Interest rates do not affect me personally, as I tend to avoid short-term loans and credit cards. However, if a major purchase (over $1,000), it may be an incentive when interest rates are low.
It would be better to spend money in this case. Since inflation is higher than interest rates, buying power decreases effectively year over year. Therefore, on $100, one would make $1 based on the interest rate, but because of the inflation rate, one would need $102 to have the same buying power. In the long term, under such conditions, inflation will virtually shrink one’s savings.
Behavioral Economic Concepts
Anchoring – a concept that can be defined as the use of outdated or irrelevant information to guide one’s financial decisions including purchases, investment, or use of financial instruments. It refers to a bias where an individual makes an incorrect financial decision based on certain assumptions or predispositions that have an emotional basis (Chen). For example, in personal spending, I purchased a used car with a car financing loan at 6.5% about 3 years ago. Recently, I was offered a similar rate on a much better and more expensive car, which I took without considering my options. Upon further research, I found that because of the dropped interest rates, I could have been eligible for a 4.5% interest rate. Due to the excitement of receiving a good deal and purchasing a car the previous time, I did not fully consider the financial aspects and changes to interest rates since then.
Prospect theory – it is a behavior economics theory which suggests that individuals perceive loss and gains differently. When given two or more independent choices, people will likely choose products or choices that they perceive as most beneficial rather than the one they see as a loss, which can be described as loss aversion. However, prospect theory highlights that everything depends on perspective regardless of the actual gains or losses or if the presented choices are relatively equal (Chen). In personal finance, when choosing a credit card recently, I was presented with several choices that had virtually similar benefits and interest rates, albeit some differences in long-term ownership and payments. Instead of considering these important aspects, since the short-term elements were similar, I made a choice with the company that seemingly marketed better and seemed like a safer and reliable company to take out a credit card with because of how I perceived it.
Works Cited
Chen, James. “Anchoring.” Investopedia, 2019.
Chen, James. “Prospect Theory.” Investopedia, 2019.