DedB asked:
Hi, folks, I wanna know what’s the correlation between interest rates and business cycles?
Hi, folks, I wanna know what’s the correlation between interest rates and business cycles?
Like, when the economy is booming , are the interest rates low or high?? And when the economy is sluggish, are the interest rates low or high?
PLUS, I wanna know which factor is the causal factor? I mean, is low/high interest rate a RESULT of economic boom/recession or is it a CAUSAL factor? Thanks
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In general, when there is more demand for credit (economic expansions), interest rates will rise, and when there is little demand for credit (like right now), interest rates will fall. However, there are other factors that influence rates — such as how fast the supply of money is being created, changes in the velocity of that money supply and the market’s expectations of inflation — so the relationship is not lockstep.
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You can find the relationship by looking at savings.
In a free market, when savings are high, interest rates will be low because banks can afford to take the extra risk. Vice versa holds true as well.
In the US, we do not have a free market, and the simplest way to show this is via the fact that we have a Federal Reserve. They set interest rates.
In that free market, low interest rates are a sign that people’s time preferences have shifted to a later time and not the present, so entrepreneurs will invest in the future that people are saving for. If interest rates are high, then people are not saving and entrepreneurs will invest in the present since that is what the population’s time preference is.
The Fed however usually sets interest rates far lower than they naturally would be. This causes us to invest in a future that we are not saving for. Of course, these investments will fail since we will not have the money to pay for these things in the future. This is the bust. What we had while the economy was growing and we had low interest rates was the unsustainable boom. The only way to correct the bust is to set interest rates higher so that we stop investing in the future that we are obviously not saving for.
The only real path to sustainable growth is to abolish the Fed and allow banks to set interest rates which would naturally be determined by savings.