The Basics of Interest Rates

An interest rate is the rate of interest a borrower pays to use the money they borrow from a lender. Changes in interest rate levels signal the status of the economy. As a vital tool of monetary policy, interest rates are kept at target levels – taking into account variables like investment, inflation, and unemployment – for the purpose of promoting economic growth and stability.

In the United States, the Federal Reserve (often referred to as "The Fed") implements monetary policies largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed.

Federal fund rates The effective federal funds rate in the U.S. charted over more than half a century.

Monetary policies are either expansionary or contractionary. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses to expand. An expansionary policy increases the total supply of money in the economy more rapidly than usual. Contractionary policy is intended to slow inflation to avoid the resulting distortions and deterioration of asset values.

Contractionary policy increases interest rate levels by expanding the money supply more slowly than usual or even shrinking it. Most central banks worldwide assume and expect that lowering interest rates (expansionary monetary policies) will increase investments and consumption. However, lowering interest rates can sometimes lead to the creation of massive economic bubbles when a large amount of investments are poured into the real estate and stock markets.

Crowding Out

Crowding out occurs when expansionary fiscal policy raises interest rates, thereby reducing investment spending. That means an increase in government spending crowds out investment spending. This change in fiscal policy shifts the equilibrium in the goods market. A fiscal expansion increases equilibrium income. If interest rates are unchanged, an increase in the level of aggregate demand will follow. This increase in demand must be met by a rise in output.

With this increase in equilibrium income, the quantity of money demanded is higher. Because there is an excessive demand for real balances, the interest rate rises. Firms' planned spending declines at higher interest rates, and thus, aggregate demand falls. The adjustment of interest rates and their impact on aggregate demand dampens the expansionary effect of increased government spending.