The fall and rise of interest rates, although they may sometimes seem counterintuitive to a saver’s intentions, actually makes a great deal of sense when communicating about the economy as a whole. Particularly with the debt slow down and credit freeze, low interest rates are critical to getting the debt and loans markets moving once again.
When talking about the nation’s economy, one must keep in mind the aggregate demand, the Gross Domestic Product of the nation. The GDP is made of four principal factors: consumption, investment, government spending, and net exports. Each of these factors contribute something to the health of our economy, but of course, in the discussion about interest rates, investment is the most important.
One would think that investment means something like putting money into a bank or putting money into the stock market – indeed, that’s why investment is very lucrative for an average person. However, in terms of the economy, this is not the definition of investment, for it does not help money flow in a circular path – the GDP and its factors, on the other hand, help insure a circular flow.
When people put money into the stock market or into the banks, this is instead called a leakage-because it leaks money away from the circle. These particular leakages are called ‘savings,’ which in the long run make much more sense. Imagine if when you saved your money, you stuck it under the bed: in this case, it should be clear that your money would be “leaked” out of the economy, because it is not being spent, so it cannot go to businesses for them to REINVEST into better products, etc.,
When the Federal Reserve considers its monetary policies, they, however, are more concerned about investment meaning what businesses can do to improve their companies, because in reality they are concerned about the GDP. When the economy is slowing down, this means that the GDP is not increasing as rapidly, and so the Federal Reserve might lower interest rates by buying government bonds (which in turn, increases the money supply) or by simply decreasing the rate of interest that banks must pay to get money from the Fed (the central bank).
These lower interest rates, although they are bad for saving, help investment because corporations will be more interested in investing money in new factories, producing more items, etc., This will raise the level of investment in the GDP, and lead to better production for everyone.
In our current economy, it is clear to see then, why interest rates might go down. Interest is best seen as the price of borrowing money. Not only companies but also families in general need quick and easy access to loans and debt, but if the interest rates are too high, then that essentially means that the cost of debt is high, and so people would be less likely to take out loans (which would put us in a credit freeze as we are in now). However, as the interest rates are lowered and as more people demand loans, then interest rates in general will rise to represent the increased demand and smoother flow of debt markets, which would help lenders earn money from the interest paid.