Financial Institutions, Markets, and Money, Eleventh Edition

CHAPTER FOUR

The Level of Interest Rates

IF YOU READ THE Wall Street Journal or watch CNN on a regular basis, you know that interest rates are constantly in the news. During the 2007–2010 recession, there were fears that interest rates would become so low that the Fed's ability to stimulate the economy might be jeopardized. Journalists sounded the alarm over the perils of low interest rates as rates hovered near zero and consumers complained that they were earning almost no interest on their savings accounts. However, with the economy stalled at 9½ percent unemployment, the Fed continued to pump more money into the financial system in an effort to reinvigorate the stalled economy.

The fundamental question addressed by this chapter is, Why are Interest rates considered such an important economic variable? They're important because they directly affect consumer and business spending. Interest rates are the cost of borrowing someone else's money to purchase goods and services, which must be paid back at a later date. The total cost of any credit purchase is the price of the product plus the interest payments. Thus, when interest rates are high, purchases become more expensive, business and consumer spending slows down, inflation is typically curbed, and economic expansion and job creation are choked off. In contrast, lower interest rates tend to encourage spending by consumers and businesses and to stimulate business expansion and job creation; however, under certain conditions, ...