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.
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