Interest Rates and the U.S. Economy

Interest rates affect the economy very slowly. However, the interest rates on bank loans and the interest rates banks pay to depositors does effect the direction of overall economic output.

The over all level of interest rates can have a profound impact on shaping people’s behavior regarding investments and consumption. The individual decisions in turn affect economic decisions that determine the well being of the nation. How much people are willing to save and how much businesses are willing to invest are fundamental forces driving the United States economy that is often heavily influenced by the interest rates. The strength or weakness of the economy in turn affects interest rates by influencing the supply and the demand for credit. Our economy has a strong tendency to move through normally returning cycles of growth and slowdown.

The Federal Reserve works to try and make sure these cycles do not lead to run away inflation or a prolonged recession. When economic activity is expanding and the outlook appears favorable, consumers demand substantial amounts of credit to finance homes, automobiles, and other major items, as well as to increase their levels of current consumption. With this positive outlook, most consumers expect higher incomes, higher levels of wealth and as a result are generally more willing to take on future debt and obligations. Businesses are also positive and will pursue money to finance the additional production, plants, and equipment needed to supply this increasing level of consumer demand. All of this makes for a relative insufficient quantity of available funds, due to increased demand. The supply of funds dwindles, the demand for funds is increasing and the end result is higher interest rates.

On the other hand, when sales are slow and the future outlook looks bleak, consumers and businesses tend to reduce their major purchases and consumption. Banks and lenders may become apprehensive about the payment ability of prospective borrowers and turn out to be hesitant to extend further credit. As a result, both the supply of and demand for credit begins to fall. Sometimes the supply and demands relatively similarly and interest rates stay stable as the economy contracts. Unless the supply and demand for credit both fall by the same amount, interest rates will be affected.

The level of current interest rates received on investments and paid to obtain loans has a considerable impact on the rate of growth or the economy. Individuals, businesses, and municipalities that borrow funds will affect the demand for credit. When interest rates are low both individuals and businesses are more likely borrow and spend. As borrowing and spending rises there is more competition for labor, raw materials and physical resources. If the pace of expansion due to low rates continues, higher inflation rates will usually develop.

This entry was posted on Sunday, October 12th, 2008 at 12:14 pm and is filed under Banking and CD Guide. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.