Today’s troubled economy actually creates a great opportunity to learn basic theories of economics.
Not a day goes by that “interest rates” aren’t discussed in print and on radio and TV.
So here is a primer on what’s up.
Market forces typically set interest rates for bonds, mortgages, and other instruments that are subject to negotiations between buyers and sellers (or borrowers and lenders).
Policy makers, both in the public and private sectors, typically set certain benchmark or policy rates that influence the market forces that drive other interest rates. Examples of interest rates set by policy include the discount rate, the federal funds rate, and the prime rate.
In the simplest terms, the Federal Reserve tends to lower key short-term interest rates when economic growth is slow to help stimulate the economy. This makes money less expensive to borrow, which can entice businesses and consumers to spend and invest more. The Fed tends to raise rates when the economy is growing fast enough to create high inflation.
We obviously have a slow economy, based on the Feds’ actions of the past year.
Spending and Employment
When the economy is growing, consumers and businesses have more money and are more likely to both lend and borrow. Consumers may be more inclined to borrow for big-ticket items such as autos and real estate. Businesses may be more inclined to borrow to increase inventories, invest in new equipment, and raise productivity and output, which in turn may lead to increased hiring.
Inflation
This is what stops the Fed from constantly reducing interest rates, as it has for months. Higher interest rates act like a brake on rapid economic growth, the most common cause of inflation. And so it can be said that interest rates influence inflation. But inflation can also influence interest rates.
When inflation is threatening, lenders may charge higher interest because they want to be compensated for the risk that their money will be worth less when they get it back from the borrower.