Lower interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic growth. The Federal Reserve Board, also referred to as "the Fed," is in charge of setting interest rates for the United States through the use of monetary policy. The Fed adjusts interest rates to affect demand for goods and services. Interest rate fluctuations can have a large effect on the stock market, inflation, and the economy as a whole. Lowering interest rates is the Fed's most powerful tool to increase investment spending in the U.S. and to attempt to steer the country clear of recessions.

Monetary Policy

Ultimately, the Fed uses monetary policy to keep the economy stable. In times of economic downturn, the Fed lowers interest rates to encourage additional investment spending. When the economy is growing and in good condition, the Fed takes measures to increase interest rates slightly to keep inflation at bay. The Fed controls the federal funds rate, which influences long-term interest rates. The federal funds rate is the interest banking institutions charge one another for overnight loans of reserves or balances that are needed to meet minimum reserve requirements set by the Fed. By setting the federal funds rate, the Fed indirectly adjusts long-term interest rates, which increases investment spending and eventually affects employment, output, and inflation.

Changes in interest rates affect the public's demand for goods and services and, thus, aggregate investment spending. A decrease in interest rates lowers the cost of borrowing, which encourages businesses to increase investment spending. Lower interest rates also give banks more incentive to lend to businesses and households, allowing them to spend more.

Advisor Insight

Scott Snider, CPF®, CRPC®
Mellen Money Management LLC, Jacksonville, FL

Yes, lower interest rates increase the speed at which you spend down your investment savings, potentially to $0. For example, if you withdraw $5,000 from a $100,000 investment, but Account A is earning 2% interest and Account B is earning 5%, Account A will run out of money in 25.8 years, whereas Account B will never run out of money. $100,000 x 5% = $5,000, which is equal to the $5,000 being taken out every year. Therefore, the money invested remains level at $100,000. Anything above 5% means the assets are appreciating in value over time, even after withdrawals. Keep in mind however that most people’s costs of living increase because of inflation, which means higher withdrawal amounts year to year. As a result, your savings deplete at a faster pace whenever rates remain low.