Low interest rates for economic recovery

We cut interest rates.

This makes:

a. consumption rise
b. exchange rate fall (hot money) thus exports (multiplier) increase
c. savings down
d. investment up
e. imports (SPICED) now more expensive
f. demand up, unemployment down thus government spending down
g. more working, tax revenue up
h. mortgages down, discretionary spending up, more spending

Thus economic problems solved...aren't they?

But maybe we should RAISE interest rates?

When individuals choose to save part of their income, they free resources (that otherwise would have been used to make consumer goods) for the production of capital goods, i.e., plant equipment and machinery. And it is through investment in the production of more and better capital goods that the society creates the ability to make more and better consumer goods over time. Savings — and the wise investment of that savings by private businesses — is what is the source of a rising standard of living and real job opportunities in the long run.

Money is the medium of exchange — it is the means through which individuals are more able to exchange efficiently and economically with one another, including transferring savings from lenders to borrowers. Creating more money does not create more capital goods. Creating more money merely means that people have more pieces of paper with which to bid against each other in the attempt to acquire control over resources and commodities in the market. In other words, the ultimate result of a monetary expansion, in an attempt to stimulate trade and jobs, is a rise in prices in general in the economy, i.e., price inflation.But in the intermediary stage between the time the supply of money is increased and prices in general in the economy have increased, there often appears the illusion of economic prosperity and productive investment. But it is a transitory prosperity and an unstable investment climate. The prosperity lasts only as long as the inflationary process keeps selling-prices rising sooner and faster than cost-prices. Artificial profit margins are the source of the appearance of prosperity, but inevitably cost increases catch up with rising sales prices, and the boom ends.

Furthermore, the lower rates of interest resulting from the monetary expansion made available for lending purposes in the banking system, induce a large number of additional investment projects to be undertaken that turn out to be unsustainable in the long run. Investment requires savings, i.e., the availability of resources for the construction and maintenance over time of new and improved capital goods. But some of these investment projects will have been started purely on the basis of the illusion of greater savings created by the availability of more money for lending purposes. When the inflation finally ends or slows down, these investments will be found to lack the necessary savings base to sustain them. Hence, the investment boom produced by the monetary expansion has within it the seeds of a future investment recession.

So -should we raise interest rates - or drop them?

1 comment:

  1. This seems to depend whether the government wants to expand the economy in the short or long run. Loosening monetary policy increasing the availibility to borrow pushes investment up. It is hard to say whether borrowing creates unsustainable investment in the long run. It seems that it depends on the nature of the projects. Raising interest rates can indeed cause a rise in savings, especially attracting hot money. However, it is hard to predict whether saving of individual consumers and domestic firms would go up. Higher interest rates will increase the costs of mortgage payments taking the potential savings money away.