Extremely non financially savvy person here. Is the idea that more people then get home loans, or there is less to pay back on credit cards? I keep seeing this and don’t quite understand.
Thanks so much.
In: Economics
Take an extreme (unrealistic) example to illustrate the idea.
Say that the inflation rate is negligible and the interest rate is 100% and you have $5000. You have the idea of taking a vacation costing $5000. Your preference is to take it this year but it isn’t all that bad to postpone it a year. Take it this year – spend $5000, net 0 left. Take it next year, invest the $5000 for a year and after that period you had the vacation and still have $5000 left. So you can evaluate the choice two different ways conceptually (both methods are valid)
1) the preference of this year over next for the vacation is worth $5000 to you
2) the option value of postponing the vacation is $5000 (this is a simplistic explanation of option value)
If the interest rate is 1%, then both the $5000 figures become $50. Now in either way of looking at this decision, it might be much easier to “cross the hurdle” and decide to have the vacation this year and forego the $50.
Once a lot of people start to make these choices when interest rates fall – the sum of that behavior is that travel agencies, airlines, retail, car mfrs start to see more immediate consumption rather than postponed consumption (ie savings) This stimulates the economy.
This conceptual framework is used to determine if companies should invest, individuals should take loans, buy houses, take a long vacation, switch jobs etc. The interest rate tends to have a large influence in all these decisions.
Let’s say you want to do something. Buy land. Start a business. Expand your business.
But you can’t afford to do so in cash. What do you do?
That’s right, you get a loan. Lowering the interest rate makes it easier to do these things. Doing these things create economic activity, and economic activity grows the economy.
Lower interest simply implies more activity in the economy. Eg home loans, car loans, general spending etc…
The Federal Reserve lowers interest rates in order to stimulate growth during a period of economic decline (COVID-19) That means that borrowing costs become cheaper.
However the underlying mechanism of artificially suppressing interest rates carries a number of deleterious effects that are deferred to a future time.
Much of the developed world has experienced a low interest rate environment since 2009 as monetary authorities from around the globe cut interest rates to effectively 0% in order to stimulate economic growth and prevent deflation.
Just as there are advantages to a low interest rate environment, there are also drawbacks, especially if the rates are kept extremely low for a long period of time. Lower borrowing rates mean investments are also affected, so anyone putting money into a savings account or a similar vehicle won’t see much of a return during this type of environment.
When you have to spend less money on bills, you spend it on something else, stimulating the economy. Say you save $100 a month more than you were doing before. The average person doesn’t hoard this money. They spend it in their community, where they may not have been spending before due to lack of funds.
A high interest rate encourages people to save and discourages them from spending. So when interest rates are high there is more money staying “stagnant” – people put their money into savings accounts because they want to earn interest. At the same time, its hard for banks to find people who want to pay those interest rates on loans. This means that banks end up with a surplus of money that they can’t loan out.
When interest rates are low people are discouraged from saving (causing them to spend the money instead), decreasing the amount of money available to banks. At the same time, its easy to find people who want to borrow money at the low interest rates. This means that banks don’t hold on to much money.
To understand how this effects the economy you have to understand that importance of the rate at which people spend money.
Imagine that you live in a world in which there is only you, a single $10 bill that you own, and me. If you don’t ever spend that $10 bill then there is $0 of economic activity.
If each month we trade the $10 bill, then there is $120 in economic activity each year (one $10 trade during each of the twelve months).
If each month we trade the $10 bill twice then now there is $240 in economic activity each year (two $10 trades during each of the twelve months).
If each month we trade the $10 bill three times then now there is $360 in economic activity each year, and so on.
In the situation in which interest rates are high and banks are sitting on a huge pile of money, the rate at which money gets spent drops (because the money is sitting idle in a bank account somewhere, rather than being spent). Because the rate at which money gets spent drops, the total amount of economic activity each year drops.
In the situation in which interest rates are low and banks are loaning out money as quick as they get it, the rate at which money gets spent increases. This increases the total amount of economic activity each year.
There are, however, limits to this. Increasing the rate at which money is spent doesn’t *necessarily* increase the amount of stuff available to buy. If you increase the rate at which money is spent too much then you end up with inflation.
There is another potential problem that we’re starting to see in the modern economy. Previously, a substantial percentage of the country saved money in banks, and didn’t have any investment in financial markets (like stocks). E-trading has made financial investing much more accessible to people, and one thing that we’re beginning to see is that low interest rates don’t actually cause people to spend their money. Instead, people are investing their money in the stock market.
This is causing a sort of feedback loop where lower rates pump the stock market, causing even more people to invest in stocks, further pumping their value. But stocks don’t actually have any economic value to the economy, so a lot of money is being directed to an unproductive use. Its a big problem right now and its why central banks are so hesitant to keep interest rates as low as they are.
Thanks so much, everyone!
Lower interest rates –> more borrowing (because money is cheap)
More borrowing –> more spending
More spending –> higher income/economic growth
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