Economics for dummies - Part I (Interest Rates)

Of the many articles I read trying to understand the meaning of various terms and their correlation, I found the article by Warren Buffet most illustrative and useful. What follows is an inspiration from the same.

In a world far far away are a bunch of people, living on islands. We start by looking at two of these islands, Squanderville and Thriftsville, the prime occupation of both the islands is farming and mining. Thrifts are hardworking people who believe in postponing life for later [;)] and work very hard ending up in producing more food than they need, Squanders on the other hand work just enough to eat what they produce and spend the rest of the time playing golf. Thrifts figure this out and start selling their surplus food to Squanders who are more than willing to buy it and save time to play more golf. Now the problem is that the Squanders trade in Squander-bucks which Thrifts cannot use in Thriftsville, they have to buy something in Squanderville to make use of the money. They start off by buying bonds issued by Squander-guv. Bond is a promise that the issuer will pay back the money with some interest later. Everyone is happy. Is it?

Lets look at Thrifts again. Thrifts are getting richer, they export more and import less (this is called a trade surplus). Now since they are getting richer, it means that there is more money in the market chasing the same amount of goods. This makes the commodities more expensive (as there is more demand and supply is the same), there is an inflation. The guv. figures that if this is to continue things will become too expensive and not all the people will be able to buy stuff. So what the guv. does is, it sucks out excess money from the market. There are a few ways to do it:

Raise the interest rates

Simple, aint it, people fall for it and tend to deposit more money in the banks as they are getting more returns in the form of interest

Sell the guv. bonds

This translates to buying the money

Increase the bank deposit ratio

Mandates the banks to store more money with the Central bank thereby making it more difficult for banks to lend out money.


Lets take a look at Squanderville now, squanders are happy playing golf, they have no motive to work harder [;)] Now the guv. wants them to work more so that the country makes money. What it does is, it makes money cheap, i.e. it makes the squanders money more easily so that they can make some good use of it. The squanders realize that this is a good opportunity to make money, they borrow money from the bank and start doing business with it. On the way they create more employment, the mines which were once too expensive to explore are now worth it as they now have easy cash that can be used to dig mines. The guv. by decreasing the rates has thus stimulated the economy. However as a side effect, the squander-bucks have become cheaper. This means that to manufacture some stuff in Squanderville has become cheaper than to import it from Thriftsville. Squanderville exporters now have an economic edge over other islands. A falling currency is better for exporters and bad for importers. Well, at least that's what it looks like.