- Lower interest rates encourage businesses to borrow for new projects and expansion.
- Consumers are more likely to spend and invest with lower borrowing costs.
- The Federal Reserve uses interest rate changes to manage economic growth and control inflation.
- Short-term and long-term rates are influenced by the federal funds rate.
- The Fed balances between stimulating growth and preventing economic overheating and inflation.
Lower interest rates increase business investment by making it cheaper and easier for businesses to borrow money 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.
Fluctuations in interest rates affect stock markets, inflation, and the overall economy, and that it is a strategy to avert recessions.
How Interest Rates Influence Economic 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.
The Federal Reserve’s Role in Economic Stability
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.
The Bottom Line
The Federal Reserve uses interest rate adjustments as a primary tool to stabilize the economy, combating both inflation and recession risks. Lower interest rates make borrowing cheaper for businesses, leading to increased investment and economic activity, and they encourage consumer spending on large purchases due to more favorable financing options.
The Fed is challenged to maintain a balance to prevent an overheated economy and control inflation by adjusting interest rates accordingly.