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How Do Interest Rates Affect The Economy?

How Do Interest Rates Affect The US Economy?
How Do Interest Rates Affect The US Economy?

How Do Interest Rates Affect The US Economy?

Little do people know, the central Federal Reserve Bank is a private bank (not a government bank like the treasury) which pretty much holds the fate of the entire US economy, and therefore most of the world as well. Many of us know or remember that the U.S. went off the gold standard in 1971, which allowed all major currencies to essentially be backed by nothing but the trust of people who trade with them. Well, that isn’t entirely true, they are backed by something – debt.

The central interest rate right now as of January 2017 is about 0.25% in the United States. Non-central banks such as Chase or Citizens bank cannot lend below this rate as a result. Before this recent rate-hike (long before) you used to be able to make money from interest in your bank account. Before the dot-com bubble burst, you could live off of the bank’s interest if you had half a million dollars in it quite well without having to do anything. Today that isn’t the case.

Interest Rates Affect Everything You Do

And here’s why: when borrowing money is cheap to do (such as with a low interest rate) people tend to borrow more and spend more. If you could get a loan for only 0.25% interest, it’s pretty close to not paying anything for money you can use right now. Just a couple years ago, the U.S. interest rate was actually 0%, which means it cost banks nothing to borrow money, and they could make large profits by charging higher rates for themselves (the independent, non-central banks). This encouraged spending and is essentially one major role that Obama’s administration played in helping to stimulate the economy. Unfortunately though, this only made matters much worse in the long run.

Low Interest = High Inflation

Some inflation is good. Inflation essentially means there is more money able to be spent in the economy. If done right, it won’t affect prices that much either, particularly when the fed reaches its goal of 2-3% inflation per year. The problem is when these things are left unchecked. For instance, in 1981 and 1982, the inflation rate was around 14%. This meant that prices of almost everything went up by 14% or more, and the dollars being saved then also lost 14% of their purchasing power every year. In this case, it acts basically as a hidden tax. Imagine if you saved $100 per month every month only to find out in 1 year that you’ve been being taxed $14 a month also. Not a very good time to save.

What the bank did to combat hyper inflation in the early 80’s was to raise the interest rates. This meant that borrowing money became more expensive, and led to both a massive recession and even some deflation. When borrowing gets expensive, people tend to save more and spend less, and the economy slows down and stops growing.

Today we have an interesting problem. Raising interest rates even slightly will have more dramatic results than before because most of the country is already in debt – about 80% to be exact. When you have a lot of debtors and suddenly make it harder for them to earn money (which companies provide when they borrow money) you have massive lay-offs, bankruptcies, and deflation. This makes the dollar stronger, but it also takes its toll on people. When 1/3rd of America doesn’t have a job, this is a major problem. This actually creates an entire group of people dependent on government assistance.

How Does This Impact Millennials?

The generation before me (yes, I’m technically a millennial) told me to work hard, go to college, and save money. It wasn’t until I actually tried this that I realized those tactics don’t work in the new economy. I’m lucky enough to have a pretty decent income, but inflation and deflationary cycles have definitely been turbulent for my generation. When there is limited room to expand globally, and the majority of people are already unemployed or under-employed, raising interest rates even slightly can cause a deflationary nightmare, the worst we’ve seen since the Great Depression, and could last as long as an entire decade. This is something that needs to happen, however. Market correction like this is part of a business cycle and will allow us to really look at ourselves and the system we work and live in to decide whether or not it’s been working for us, and perhaps build a new one in the process. Within a generation, this will happen.

Or possibly things could inflate out of control altogether, and we will see rates go into negative territory for the first time in American history. This means that borrowers will actually be paid to borrow. With this logic, if you think about it, it means that it is more expensive to save to buy something rather than borrow to buy something. It could easily result in a cashless society in the long run if left unchecked, because cheap and easy credit will be more readily available than physical cash. In effect, it already is that way, for only about 10% of all America’s money is physically cash. Right now there does not appear to be any good outcome and it’s nothing short of a miracle and display of God’s mercy that we are still not only functioning, but the strongest nation on the world. The burden of this generation is to overcome the final phase of our business cycle and reform it. This could lead to a very bright future at some point, but not without initial pain.

What pain? Well, statistically, this generation is in its prime spending years right now. We are officially the new largest generation because the baby-boomers are going into their retirement years or dying. Sorry to sound so callous. This “sounds” like good news right? A new generation of spenders, yay! Wrong. Only 3 out of 6 millennial even have a job. And out of those 3 millennials, 1 of them is entrenched in student debt, another is only working part time, and only 1 out of 6 of them has either a full time job or a business. You can start to see now, if you’ve been paying attention, that raising interest rates too high will have its greatest toll on the current generation more-so than the older ones who already have some kind of nest-egg and no-longer need to earn as much (unless they depend on social security).

So now you know a little about how interest rates effect the economy. What do you think about it? What are your suggestions on fixing it? Leave your take in the comments!