Editor’s note: Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. His “You Decide” column is distributed by NCSU.
RALEIGH – Recently the Federal Reserve lowered its key short-term interest rate by one-half percentage point.
Most press reports interpreted the Fed’s move positively, saying it would help the economy by reducing borrowing costs. In particular, lower interest rates would assist the struggling housing market both by making it less expensive for folks to buy homes as well as by taking some of the pressure off existing owners with adjustable-rate mortgages. The rise in rates on adjustable mortgages has been a major factor behind soaring home foreclosures.
Yet attached to some of the media analysis was a "but," a reference to the fact that everyone won’t benefit from lower interest rates. In particular, savers are hurt when interest rates drop, especially those putting their money in safe investments like bank and credit union certificates of deposit.
This is not unusual in economics. There are many examples of pluses and minuses from the same economic change. A reduction in the price of lumber is good for homebuilders and homebuyers but bad for tree farmers, sawmills and lumberyards. Higher unemployment gives employers a wider pool of workers to hire, but also results in lower wages for those workers.
And straight from today’s headlines, a lower-valued U.S. dollar compared to foreign currencies makes traveling abroad and buying imported products more expensive, but puts smiles on the faces of U.S. companies selling products abroad and is also a magnet for attracting foreign tourists to the U.S.
What I’ll broadly call "prices" – interest and wage rates, prices of products and services, the value of the U.S. dollar against foreign currencies – rarely please everyone. Those on the receiving end of the price, like the seller, investor or worker, want them high. But those on the paying end of the price, like the buyer, borrower or employer, are better off if the price is low.
Who or what determines the level of prices?
In countries run by a dictator or central authority – (so-called command economies) – the government sets prices. Yet the track record of such price setting isn’t very good. If prices are set very low, as they often are on consumer goods, then shortages usually follow. In other words, if the price is set such that the amount consumers want to purchase is significantly greater than the amount businesses want to produce and sell, then the shelves will be bare and long waiting lines will develop for a chance at getting whatever is available.
In our economy, the government doesn’t set most prices. Instead, prices are free to move up and down and to settle at whatever level conditions determine.
What are these conditions? Well, for any of you who took Econ 101, you know what they are: supply and demand.
The setting of a price involves a process that looks a lot like a teeter-totter. One side of the teeter-totter is demand, which represents buyers. The other side is supply, which stands for sellers. When there is more to sell than what buyers want to purchase, the weight of the teeter-totter shifts to the supply side, and the price falls. Conversely, when buyers want to purchase more than sellers have available, the weight shifts to the demand side, and the price rises. Only when demand (the amount buyers want to purchase) equals supply (the amount sellers want to provide) will the teeter-totter be perfectly balanced, and the price stabilized
Whether a low price or a high price wins out depends on the relative strength of supply and demand. But there’s more. If a high price exists and results in exceptional profits to suppliers, then eventually other suppliers move in, supply rises, and the teeter-totter price falls. For example, today corn prices are high due to the heightened interest in corn-based ethanol. However, eventually corn prices will drop as today’s profitable prices encourage farmers – including those who never grew corn – to plant more rows.
The movement of prices and the constant interplay between supply and demand is a fascinating phenomenon for economists to watch. For many others, it is frustrating.
If you’re in the latter category, keep the teeter-totter analogy in mind and maybe you’ll decide that what makes a price go up or down is not so mysterious after all!
Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy.