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Interest Rates and The Economy |
Lower interest rates make it easier for people to borrow
in order to buy cars and homes. Purchases of homes, in
turn, increase the demand for other items, such as furniture
and appliances, thus providing an additional boost to
the economy.
Lower interest rates mean that consumers spend less
on interest costs, leaving them with more of their income
to spend on goods and services.
Lower interest rates make it easier for farmers, manufacturers,
and other businesses to borrow to invest in equipment,
inventories, and buildings. Also, the returns that investments
will produce in future years are worth more today when
rates are low than when rates are high. That gives business
more of an incentive to invest when rates are low. Increased
business investment, in turn, makes the economy grow
faster, as productivity, or output per worker, increases
faster.
Interest rates do not seem to affect the amount that
people save. That’s because higher interest rates have
two conflicting effects on how much people save. First,
the higher return that savings can earn gives people
an incentive to save more. Second, however, the higher
return makes savers feel richer, so they may spend more,
rather than save more.
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Interest rates can affect the value of the dollar versus
that of other countries’ currencies. All other things
held constant, when real (inflation-adjusted) interest
rates are higher in the United States than in other countries,
foreigners want to invest their funds here in order to
earn a high return. The resulting increase in the demand
for the dollar pushes up the value of the dollar. The
opposite can happen when U.S. interest rates are low.
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The health of the economy affects interest rates by
influencing the supply of, and the demand for, credit.
For example:
People’s incomes fall in a recession, so the amount
they save also decreases.
The demand for credit by business generally declines
in a recession, as business spends less on new buildings,
equipment, and inventories. Also, the Federal Reserve
acts to reduce interest rates during recessions, in
order to stimulate economic activity.
The federal government’s demand for credit generally
rises in a recession, as the reduction in business and
consumer incomes reduces tax revenues, and programs
such as unemployment insurance require increased spending.
The net effect of all of these changes is that interest
rates often go down in a recession.
All other things held constant, the rising demand for
credit in expansions pushes interest rates up. If the
rates that consumers and businesses have to pay to borrow
rise too rapidly, however, spending may decline, leading
to an economic slowdown.
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