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
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.
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