Are Low Interest Rates Good for the Economy?

Interest rates are the rate at which the central bank of an economy pays to commercial banks that hold money with them. Thus, they are set by the central bank and affect economic activity in an economy. Interest rates are often used during times of distress but also when an economy is overheating.

The main argument for low interest rates is that they increase spending and reduce savings. “Interest rates ought to below where there is an excess of savings and spending is weak,” which often occur during recessions or economic shocks. Thus, reducing the rate at which depositors earn on their savings while simultaneously reducing borrowing costs for consumers and firms can reverse current saving patterns. Consequently, this results in higher aggregate demand in the economy and can help an economy recover from an economic downturn. Though, low interest rates alone may not be enough to stimulate spending, as stubborn consumers and firms facing uncertain economic conditions may continue to save their cash regardless of the rate they receive. Despite this, the argument that low interest rates increase spending and reduce savings is the principal theory behind the policy decision and is a valid one.

Another argument for low interest rates is that they can be manipulated quickly and easily. The Monetary Policy Committee at the Bank of England meets every 6th Thursday to decide the interest rate and even increase their meetings’ frequency if necessary. Hence, “central banks can adjust their policy settings swiftly to shifts in the business cycle,” which is vital during sudden shocks to the economy where rapid reforms are required, something that fiscal policy cannot do since passing laws through the Senate in the US, for example, is a long and arduous process. Though low interest rates can be implemented rapidly, their effect on the economy is not immediate and is not as spontaneous as their response. Despite this, one of the greatest things about interest rate policy is that they can be manipulated regularly and respond to the economy quickly, and this argument for low interest rates is therefore valid.

On the other hand, low interest rates make it harder for pensioners to retire. Since government bond yields move relative to interest rates, lower interest rates mean lower yields on government bonds, financial assets held predominately by pensioners looking for a reliable and consistent source of income into retirement. An individual looking to retire on £10,000 a year would require £200,000 in savings at a yield of 5% to live off. If the yields on government bonds slipped to 1%, the individual would now require £1,000,000 in savings if they wish to retire. Contrary to this, low interest rates are likely to result in a rise in other assets prices, meaning that those looking to retire should shift their money to equities if they are looking for greater profits. However, this is a far riskier investment strategy and does not provide consistent and reliable income as government bonds have historically provided. Hence, the view that low interest rates make it harder for pensioners to retire is very valid.

Another argument against low interest rates is that they encourage excessive risk-taking. Lower costs of borrowing, rising asset prices and poor returns on saving accounts make a toxic potion for increased leverage. Investors purchase equities and financial contracts with borrowed money, and firms partake in highly leveraged buyouts with very little capital coverage. If these products or businesses fail, this can result in enormous losses for individuals and firms, enhancing the downturn in an economy. Despite this, low borrowing costs can be seen as a positive for individuals and firms as they can invest while it is cheap, leading to higher profit margins in the future. It also allows firms to expand their market share, which can help to drive productivity so long as they do not gain monopoly power. Hence, this final argument is invalid as its effects on risk-taking are favourable for an economy.

To conclude, while low interest rates make it harder for individuals to save for retirement and may cause excessive and irrational risk-taking, their benefits are far more desirable. Being able to manipulate and dampen the business cycle during an economic downturn is a vital tool for a central bank to possess, especially considering the speed at which it can be done. Keynes’s beliefs that governments should intervene during recessions have provided the foundation behind lowering interest rates, and long may this continue.

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Ted Jeffery

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A student passionate about economics and how the world works. New blog post every Monday.

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Ted Jeffery

Ted Jeffery

A student passionate about economics and how the world works. New blog post every Monday.

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