Interest rates affect the decisions you make with money. Some of these are obvious – think about how much more money you would stick in your savings account if it paid 15% interest instead of 0.5%. How much less money would you put into stocks or your 401(k) if you could get 15% in a simple bank account? On the flip side, you might take out a new credit card at 3%, but you probably wouldn't borrow at 30% unless you absolutely needed to.
There are less obvious impacts, too. For entrepreneurs and bankers, interest rates affect calculations about future profitability. For instance, it's easy to enter the capital markets and finance a new project when interest rates are at historic lows, but the same project might not be a money maker long term if expected interest payments double. This, in turn, affects which products and services are offered in the economy, which jobs become available and how investments are structured.
Interest Rates and Coordination
Interest serves several crucial functions in a market economy. The most obvious is the coordination between savers and borrowers; savers are paid interest for putting off their consumption until a future date, while borrowers must pay interest to consume more in the present. When there are relatively more savings, the supply of loanable funds increases and its price – the interest rate – should drop. When more people want to borrow than current savings can satisfy, the price of new money is driven up and interest rates should rise.
Since interest rates affect how much new bank loan money is circulating in the economy, they have a direct impact on the deposit multiplier and, by extension, inflation. This is why the classic Fed remedy for high inflation is to raise interest rates.
There is no uniform or single natural rate of interest; the interest costs depend on the physical supply and demand characteristics for each market. There are several foundational interest rates in the economy, especially when they are influenced by a central bank, such as the Federal Reserve. Changes in these interest rates, such as the federal funds rate or the discount rate, can affect the entire shape of the economy.
Interest Rates and the Economy's Geometry
Interest rates go a long way in determining the geometry of the economy, meaning the actual distribution of labor and resources. It matters which industries grow and which industries shrink, and where people are deploying financial and physical capital. Interest rates guide much of that movement.
People often talk about the economy in terms of large aggregates. Read over a report by the U.S. Bureau of Labor Statistics (BLS) or the National Bureau of Economic Research (NBER) or turn on the talking heads on CNBC, and you'll hear terms such as "total consumer spending" or "net manufacturing output." It's simpler to paint broad topics with a macroeconomics brush; even most professional economists default to this kind of analysis.
The problem with focusing on the broad and the macro is that you're likely to miss important distinctions. Big numbers never tell the whole story. For example, according to the Bureau of Economic Analysis (BEA), real GDP of the United States in 2014 was 2.4%, far below the 4.4% posted in 2004. This doesn't necessarily mean that the economy was twice as strong in 2004, however.
Interest Rates and the Housing Bubble
The economy in 2004 wasn't very healthy at all; it was buoyed by an out-of-control housing market. The U.S. saw record home sales and property values for six consecutive years starting in 2001 when the Federal Reserve lowered its targeted federal funds' rate from 5.5% to 1.75%. Without that dramatic slash in interest rates, it's highly unlikely that the housing market would have exploded in the same way.
Low-interest rates made borrowing for mortgages too easy. It also made long-term, capital-intensive projects, such as home construction, too easy to undertake. Homebuilders and homebuyers became intoxicated on cheap money, leading to disastrous distortions in economic activity that the macro numbers, such as GDP, couldn't pick up until the Great Recession was in full swing.
Consider the economic incentives created by low-interest rates, such as borrowing more, starting long-term projects, saving less and investing in riskier assets to beat inflation. Too many people were employed in home construction or finance in 2004 because the economic demand for their services was predicated on false signals. In other words, the shape of the economy was all wrong. Many of these people lost their jobs between 2007 and 2009 when reality sank in and the entire world felt the impact of a misguided interest rate policy.