This is mainly regarding US economics and the news. I frequently heard (especially the last couple months) about how the US interest rates went up/down.
Also it seems that interest rates are sort of used as a measure of the “health” of the economy? But why? What do interest rates mean for the economy overall? What are the impacts of a rising/falling interest rate on the economy?
In: Economics
The federal funds rate is set by the Federal Reserve or the simply put the countries bank. This is the rate at which banks borrow from the US Government.
The prime rate is directly correlated to this rate.
When the economy is struggling rates fall so that it becomes less attractive to save (as bank deposits yield lower returns) and more attractive to borrow. This borrowing results in economic activity that will help improve the health of a struggling economy. This could come at the expense of inflation as spending tends to increase. The demand for goods and services outpaces the supply and prices will rise to offset.
When the economy is healthy and/or there is a need to slow inflation, rates will rise. The intention is for there to be the opposite effect. Variable debt gets more expensive (mostly credit cards) resulting in less collective disposable cash for the economy curbing spending. Lending becomes more expensive discouraging people from borrowing and thus spending. Lastly fixed income investments and bank deposits become more attractive as they now pay more interest or dividends. Demand will decrease and inflation will slow as a result of less demand for goods and services.
This is a simplistic explanation, there are other variables and policies that impact the economy.
An interest rate is basically a price for money that you borrow. If you walked into a bank and met with a loan officer, they’d show you a potential loan with an interest rate attached to it. That interest rate reflects a lot of factors (creditworthiness, duration, loan amount, use of proceeds, etc), but ultimately it’s a price you pay for the money. Want $30,000? The bank will loan it to you for 10% interest, and you pay $3,000 every year until the term expires, or you repay it, whichever is earlier.
Low interest rates means that prices for money are low. That means that you don’t have to pay as much to the bank to borrow it. That $30,000 you borrowed above? Let’s say we’re in a low rate environment. The loan might be 1%. So instead of paying $3,000, you only pay $300 every year. That’s a better deal for you, the borrower! And it’s a better deal for a lot of other people too. People borrow a lot of money to use for whatever uses they need – repay credit cards, buy a house, acquire a company, speculate on stocks, make risky investments, take vacations, and so on.
These low interest rates are so widely taken advantage of by so many people & companies that they have a major impact on the economy writ large. Companies can afford take on riskier projects, invest in infrastructure, grow their business footprint to handle increased consumer demand, etc.
The economic boom generated from low rates can sometimes push an economy to grow too quickly. Consumers might be willing to pay more for the things they like. Money’s cheap, and times are looking good, right? Not always. Companies raise prices in response to increased demand, which makes lifestyles harder to sustain for an average family. These increased prices bring about higher inflation, which, if grown too quickly, indicates that people are willing to pay higher and higher prices. If left unchecked, prices could grow at faster and faster rates.
Runaway inflation is a deadly problem for an economy, so central bankers respond by raising interest rates. They raise the price of money. This makes growth projects tougher to pay for, houses harder to buy, and loans for speculative things tougher to approve. It slows the flow of cash, which affects enough people to slow the economy. To combat higher costs, some companies will lay off workers, tighten spending, and suspend growth projects. The economy’s growth slows accordingly. Prices don’t grow as quickly. And eventually, the economy might even shrink, otherwise known as a recession.
Eventually, unemployment and inflation get so high and low, respectively, that central bankers lower the price of money (via interest rate reductions) to stimulate the economy and encourage companies and consumers to spend more. And then we return to economic prosperity and growth.
This flux between high rate / slow economy and low rate / fast economy is known as the business cycle, and the US economy went through a very extreme example of it between 2020 and today. Sharp economic shocks from lockdowns caused massive layoffs. Spending halted almost completely. Interest rates dropped to near-zero. Spending and investment grew, and grew so quickly that the economy and inflation grew quickly. So rates rose to slow inflation.
TL;DR – Interest rates measure the price of money. Lower means people & companies can borrow more at low cost. They do more things with more money, which grows the whole economy. If it grows too fast, prices of food, services, and money (via interest rates) grow too.
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