Quezi

Interest Rates (photo by ArtemFinland - CC-BY)

The interest rate policy of a central bank affects the economy, that’s for sure. What can be achieved by varying the interest rate? Is it possible to stabilize the economy using interest rate variations as a tool?

Every aspect of the economy is interlinked. The central bank can use interest rate policy to stabilize one measure of the economy, but it can’t stabilize them all at the same time.

The most common stated policy of central banks (as of 2009) is to target a stable inflation rate. If inflation rises, the bank can increase interest rates, which reduces the money supply and therefore increases the value of the money in circulation and reduces inflation. If inflation falls too far (is such a thing possible?), the bank can decrease interest rates, which increases the money supply and therefore decreases the value of the money in circulation, causing inflation.

If inflation in one country is higher or lower than that of its trading partners, the exchange rate will vary to preserve equivalent exchange value. If the inflation rate in one country is higher, that country’s currency will become worth relatively less over time, measured against other currencies. If the inflation rate is lower, that country’s currency will become worth relatively more.

An alternative policy allows a central bank to target a stable exchange rate. If the exchange rate is lower than desired, the central bank can raise interest rates. The resultant inflow of capital from investors will increase demand for the currency, raising its exchange rate. If the exchange rate is higher than desired, the central bank can lower the interest rates and the outflow of capital will reduce the demand for (and therefore the value of) the currency.

If monetary policy (via interest rates) is used to maintain a stable exchange rate, then variations of productivity between countries will lead to varying rates of inflation in those countries.

A third policy allows a central bank to set its interest rates to target … wait for it … a stable interest rate! If individuals and businesses know that interest rates are likely to remain stable, they can plan for the future, confident that their savings will grow at a predictable rate and that repayments due on their borrowings will remain stable.

If interest rates are held stable, both inflation and exchange rates will vary according to variations in the productivity of each country, but such changes are likely to be gradual.

The effects of interest rate policy are not limited to inflation, exchange rates, investment income and loan repayments. A major side-effect of any shift in interest rates is to move prosperity from savers to borrowers or vice-versa. When rates are low, borrowers benefit. When rates are high, savers benefit. “Savings” doesn’t just include individual savings accounts, it also include pension funds and the long-term government securities (known as gilts in the UK) that can be used to assure annuity payments.

One thing that interest rate policy cannot achieve, no matter how much politicians want to believe it, is to “boost the economy”. If that really worked, we would simply do it more and more, and would soon be living in economic paradise. You can’t get something for nothing. Economic prosperity only comes from productivity – people working to produce stuff (goods or services). Producing prosperity any other way is as much an illusion as the magician pulling a rabbit out of a hat.

That’s how it looks to me, anyway. Feel free to set me straight in the comments.