Understanding the Rise and Fall of Interest Rates

Interest rates are one of the major factors affecting how the economy performs. A relatively low interest rate will encourage businesses to borrow more money for investment into new plants, equipment and buildings. This will cause the combined economic output of those companies to rise.

When talking about economic output on a national scale, we are talking about GDP, Gross Domestic Product. Low interest rates help to grow this GDP figure, and generally help a country improve its economic standing. Low rates are not a panacea. It is possible for rates to get too low.

When a rate gets too low, the available of money is said to be ‘easy’. Easy money is available to just about any company or individual that wants to take on low debt repayments. Easy money allows for the quick expansion of business to a certain point. All that money is going to be spent on raw materials for making more goods to sell. Eventually, there is more money available than raw materials, so the price of the raw materials will rise – sometimes very rapidly.

This rise in raw material prices will filter its way down to finished goods. This means that you and I will pay more and more for everything we buy. This rise in prices is known as inflation. Current economic theory sees a little bit of inflation as a good thing. Too much inflation gets to be a major problem, as eventually the money we have becomes worthless.

This can, and has, happened. Many South American and African countries have experienced this recently. Hyperinflation, as it is called, really destroys a country’s economy and it takes a long time for families, businesses and jobs to recover.

High interest rates are used to prevent inflation by making money more expensive to borrow. This causes fewer people and companies to borrow money, and help to shrink the money supply. Businesses expand more slowly, and businesses that are not well run will fail. The failure of weak businesses is actually a good thing, since it frees up the supplies and money for the stronger companies that will make better use of it. Still, it is a painful experience to be involved in.

Interest rates that are too high slow the economy down too much, putting many people out of work. This lack of workers means people have less money and so they buy less goods. Fewer good bought leads to more lay-offs and less economic activity in a self-fulfilling circle.

The governmental bodies that set interest rates are away of these impacts. They try to keep track of how the economy is doing and keep it growing steadily. In the United States, this entity is the Federal Reserve system. The Fed, as it is known, cannot control all interest rates. What it can control is known as the discount rate. The discount rate is the rate at which banks loan each other money overnight. Most other rates however, rise and fall with the discount rate.

With everything tied together, the Fed has the ability to make adjustments to the flow of money in the economy by adjusting its own interest rates. As long as they do not get too far out of line with other impacts on the economy, they can help push the economy into that healthy, steady growth, which is the goal after all.