Relationship Between Interest Rate & Level of Production

Relationship Between Interest Rate & Level of Production
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The interest rate is both a cause and effect of the level of production, which makes it very difficult to manage at a macroeconomic level. This is because access to money is both what drives an economy and an effect of its ups and downs.

Private Banks: High Interest Rates

When a private bank offers high interest rates, it discourages people from getting loans to pay for new houses, add capital to their businesses and buy equipment. High interest rates can stifle the general level of production in the economy. Private banks may inadvertently stifle the level of production, but they do so in response to the amount of demand for debt. They do not try to stifle production, as this would cause their profits to become lower.

Private Banks: Low Interest Rates

When private banks offer low interest rates, the access to capital for new enterprises is increased. Businesses can be started or expanded, rents are lower, and there is generally more money flowing in the economy, which means the level of production is increased. However, private banks only do this when the level of production is already increasing--they respond to a demand for debt rather than trying to create it.

Reserve Bank: High Interest Rates

The Federal Reserve, which loans money to private banks, has different goals. It sets interest rates at high levels when there is so much new money in the economy that the price of goods is rising, so as to reduce the value of money (demand-pull inflation). This means that the Fed increases interest rates when the level of production is high in order to make it lower.

Reserve Bank: Low Interest Rates

The Fed loans money to private banks at lower levels when it is trying to increase the levels of production. This is when inflation is rising because of a rise in the price of goods, due to taxes, changes in the dollar's value on international markets, or numerous other factors. The Fed does this in order to stimulate production to higher levels, but does it when production is at lower levels.

Catastrophic Effects

Interest rates can also have catastrophic effects on production levels if they are set at levels that are too low for the levels of production. This means that demand for debt is increased, but the supply of money to pay it is not commensurate with this demand. This can cause massive bank failure, as was evident in late 2008. When banking systems collapse to this magnitude, people lose their jobs, mortgages, and means of income, and wide-scale levels of production are dramatically reduced.