Interest Rates and The Economy
- How do interest rates affect the economy?
- How does the health of the economy affect interest rates?
- How do interest rates affect the value of the U.S. dollar in
the foreign exchange market?
How Do Interest Rates Affect the Economy?
Lower interest rates make it easier for people to borrow in order to buy cars and homes. Purchases of homes, in turn, increase the demand for other items, such as furniture and appliances, thus providing an additional boost to the economy.
Lower interest rates mean that consumers spend less on interest costs, leaving them with more of their income to spend on goods and services.
Lower interest rates make it easier for farmers, manufacturers, and other businesses to borrow to invest in equipment, inventories, and buildings. Also, the returns that investments will produce in future years are worth more today when rates are low than when rates are high. That gives business more of an incentive to invest when rates are low. Increased business investment, in turn, makes the economy grow faster, as productivity, or output per worker, increases faster.
Interest rates do not seem to affect the amount that people save. That’s because higher interest rates have two conflicting effects on how much people save. First, the higher return that savings can earn gives people an incentive to save more. Second, however, the higher return makes savers feel richer, so they may spend more, rather than save more.
How Do Interest Rates Affect The Value of the U.S. Dollar in the Foreign Exchange Market?
Interest rates can affect the value of the dollar versus that of other countries’ currencies. All other things held constant, when real (inflation-adjusted) interest rates are higher in the United States than in other countries, foreigners want to invest their funds here in order to earn a high return. The resulting increase in the demand for the dollar pushes up the value of the dollar. The opposite can happen when U.S. interest rates are low.
How Does the Health of the Economy Affect Interest Rates?
The health of the economy affects interest rates by influencing the supply of, and the demand for, credit. For example:
People’s incomes fall in a recession, so the amount they save also decreases.
The demand for credit by business generally declines in a recession, as business spends less on new buildings, equipment, and inventories. Also, the Federal Reserve acts to reduce interest rates during recessions, in order to stimulate economic activity.
The federal government’s demand for credit generally rises in a recession, as the reduction in business and consumer incomes reduces tax revenues, and programs such as unemployment insurance require increased spending.
The net effect of all of these changes is that interest rates often go down in a recession.
All other things held constant, the rising demand for credit in expansions pushes interest rates up. If the rates that consumers and businesses have to pay to borrow rise too rapidly, however, spending may decline, leading to an economic slowdown.
