Lower interest rates increase business investment by making it cheaper and easier for businesses to borrow money in order to finance new projects. They have much the same effect on consumers, who might act on a major new purchase or buy a home because low financing rates make it achievable.
Lowering interest rates to boost the economy or increasing rates to slow it down is a key part of national monetary policy. In the U.S., the Federal Reserve Board, usually referred to as the Fed, adjusts interest rates to keep prices and demand for goods and services steady.
- Lower interest rates make big-ticket items cheaper for both businesses and consumers.
- Businesses take advantage of lower rates to invest in expansion.
- Consumers borrow more and buy more, justifying more business expansion.
Interest Rates and Monetary Policy
Interest rate fluctuations have a substantial 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.
How the Fed Acts
There are many interest rates at any given time. A consumer will pay one rate for credit card debt, another for a home mortgage, and yet another for a new car. They will be offered interest on a savings account at a certain rate or a little more interest on a certificate of deposit.
Ultimately, the Fed uses monetary policy to keep the economy stable. During an economic downturn, the Fed may lower interest rates to encourage additional investment spending. When the economy is growing too fast, the Fed may increase interest rates slightly to keep inflation at bay.
Business rates vary as well, depending on the soundness of the company and its ability to offer collateral for a loan.
All of those short-term and long-term interest rates are derived from the federal funds rate to some extent.
About the Federal Funds Rate
The federal funds rate is the shortest of short-term interest rates. It's the interest that banking institutions charge one another for overnight loans of cash 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.
It is long-term rates that affect investment spending. Lower interest rates for consumers mean more spending. Lower interest rates for business mean increased production of goods, and the creation of new jobs for the people who produce, sell, and deliver the goods.
However, the Fed has a delicate balancing act to perform. An overheated economy can eventually cause shortages of products and labor. That causes inflation.
To prevent inflation, the Fed may begin to gradually raise interest rates. It gets more expensive to borrow money. Both businesses and consumers step back their spending, hopefully just enough to keep a healthy economy going.