Courses

Are Low Interest Rates Good?

Speakers
Antony Davies,

Release Date
June 1, 2012

Topic

The Fed & Monetary Policy
Description

The cost of borrowing money is at a record low. Low interest rates and cheap credit encourage people to spend more, and to save less. Is this good or bad?
Many argue that we need low interest rates to encourage spending. But low interest rates don’t actually encourage people to spend more money. Low interest rates simply encourage people to spend more money now, and less in the future. The opposite is true for high interest rates.
So what interest rate is best overall? Professor Davies says the best interest rate is the one that comes about naturally, without government intervention. Individuals know better than the Federal Reserve how and when to spend their money. Decisions on whether to consume more or save more is best left to individuals, not government officials.

Are Low Interest Rates Good?
Mortgage interest rates are at historically low levels and have been for a long time. Low interest rates are good for borrowers because it means that it costs less for them to borrow. But low interest rates are bad for savers because it means that they earn a lower return on their savings. Similarly, high interest rates are bad for borrowers because it means that they must pay more to borrow money. But, high interest rates are good for savers because it means that they earn more interest on their savings. In 1972, mortgage rates were 7 percent and the average American household’s debt was 76 percent of its income. Mortgage interest rates rose until 1981 and then fell. 

As mortgage rates rose, people borrowed less. And as mortgage rates fell, people borrowed more. Today, mortgage interest rates are almost half of what they were in the 1970s, allowing households to borrow about twice what they could afford then. Some argue that we need interest rates to be low so as to encourage spending. But, low interest rates don’t simply encourage people to spend more. They encourage people to spend more now in exchange for spending less in the future. Since borrowed money must be paid back, the additional spending that goes on today will be offset by lesser spending in the future when people pay back their loans. Similarly, high interest rates don’t simply encourage people to spend less. They encourage people to spend less now in exchange for spending more in the future. So what is the right interest rate?
The answer is the free market interest rate. The free market interest rate is the rate we get when the Federal Reserve does not interfere in financial markets. Individual borrowers and savers know better than the Federal Reserve whether they should give up spending tomorrow in exchange for more spending today or whether they should give up spending today in exchange for more spending tomorrow. When the Federal Reserve actively manages interest rates it replaces these people’s judgments about what’s best for them with the Federal Reserve’s judgment as to what’s best for them. The lesson is that borrowing and saving are really about deciding whether to consume more now and less later or more later and less now. And these decisions are best left to individuals.

GET CONTENT STRAIGHT TO YOUR INBOX