The Effects of Low Interest Rates on the Economy

The term "monetary policy" refers to the actions taken by the Federal Reserve to increase or decrease interest rates in an effort to control inflation, GDP growth, employment and other economic indicators. Low interest rates can have significant effects on the economy, but there are many other factors to consider when determining the overall condition of the economy.

Lower Borrowing Costs

When the Federal Reserve lowers the federal funds rate, real interest rates tend to decrease as well. Lower real interest rates encourage borrowing from both businesses and households. The ability to borrow money at more attractive rates stimulates investment in durable consumer goods, such as automobiles, and in operational necessities such as buildings and capital equipment for businesses.

Stock Valuations

Lower interest rates tend to shift investor preference away from bonds and into stocks. According to frbsf.org, the increase in stock trading volume has the effect of raising the value of existing stock portfolios, which in turn stimulates consumer and business spending across the country due to the psychological effects of rapid capital appreciation.

Weaker Currency Values

Lower interest rates can have negative effects on the value of the U.S. dollar compared to other currencies. As foreign investors dump their dollar-denominated investments in favor of more profitable currencies, exchange rates can shift to the detriment of the dollar. The weakening of the U.S. dollar serves to increase the attractiveness of U.S. goods to foreign purchasers, which has the effect of boosting U.S. exports and international sales.

Increased Output and Employment

All of the factors mentioned above have the combined effect of increasing productive output, or GDP, and increasing employment across a wide range of industries. As individuals, businesses and foreign investors are encouraged to spend more due to increased access to capital, higher portfolio valuations and weaker currency values, businesses in nearly every sector experience an increase in sales, often requiring them to grow their operations and employ additional labor.

Considerations

While the effects of low interest rates on the economy are well defined in theory, there are many additional factors that must be considered when determining the precise impact that any monetary policy action will have on the economy as a whole. Investors' expectations of future Federal Reserve actions can play a large role in determining long-term interest rates, which in turn can affect future inflation and employment rates. Professor Larry Allen offers an example in the 2004 article "Did Lowering Interest Rates Actually Help the Economy?" by pointing out that Japan, which struggled for more than three years at the turn of the century to boost GDP growth and employment by maintaining low interest rates, experienced little to no effect.

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