Interest rates make up some of the most basic components of finance, but there’s more to them than simple numbers. Rates can affect the way consumers spend and save, the value of the U.S. Dollar overseas, and how the economy fares on a large scale.
The Federal Reserve Bank of New York recently published a valuable how-to piece that explains the affect of rates on the economy.
For a run-down of the basics on interest, read this. On that page, the NY Fed defines interest — the price someone pays for the temporary use of their funds — and lays out the reasons why interest is important to lenders and borrowers. The main thing to take away is that you will pay interest if you take out a loan or a mortgage on a home and that you will earn interest if you put money in a bank account.
Relationship Between Rates And Economy
Interest rates affect borrowers and investors on a daily basis by controlling how much consumers spend on large-scale purchases and how much they have left over.
Lower interest rates — which the U.S. government helps control — make large purchases such as vehicles and homes more affordable for consumers. In turn, those purchases help stimulate the economy: The construction and manufacturing sectors fare well, and consumers spend additional money on appliances and housewares. Lower interest rates leave consumers disposable income to make additional purchases. Low rates also allow businesses extra money to invest in new technologies and equipment.
Beyond impacting Americans’ account balances and loan payments, interest rates are tied to the health of the larger U.S. economy.
When the economy falls into a recession, as it did recently, the overall demand for credit usually goes down. That causes interest rates to go down, as we have seen over the past several years. On April 30, 2008, the Federal Reserve’s Federal Funds Rate (which it uses to help set nationwide rates) was 2.37%. On April 23, 2010, the Federal Funds Rate had fallen to 0.20%. In the case of an economic expansion, interest rates tend to go up. That has happened in the past few weeks, as the rate has risen from 0.11% on February 24.
When the U.S. economy expands and interest rates rise, it makes investing in America more appealing to foreign investors. The value of the dollar then increases. When the American economy struggles and interest rates go down, foreign investors have little incentive to save money in the U.S., causing the dollar to lose value.
The Fed’s Influence On Interest Rates
The main goal of the Fed is to help the U.S. achieve economic stability, high employment rates and healthy economic growth. The Fed tries to achieve that goal by influencing interest rates across the economy by using the Federal Funds Rate.
The Federal Funds Rate is the rate all banks must pay when they borrow money, so it helps regulate the rates they charge people who borrow from them. In the case of an economic downturn or recession, the Fed often holds the Federal Funds Rate down in an effort to stimulate consumer activity.
As the economy gradually pulls out of its recent rut, the Fed has reportedly contemplated raising rates from their near-zero level. The result of a two-day meeting this week could be an increased Federal Funds Rate, but no rate hikes are expected until the Fed feels even more confident about the economy, according to CNNMoney.com.The wait for higher interest rates could reportedly last until late this year.