Lowering interest rates by a government’s central bank affects the economy in several key ways:
Stimulates Economic Growth
- Lower interest rates reduce the cost of borrowing for businesses and consumers. This encourages companies to take loans for investment in expansion, infrastructure, and hiring, while consumers are more likely to borrow for big purchases like homes and cars. This increased borrowing and spending boosts overall economic activity and growth
Increases Consumer Spending
- With cheaper credit, consumers have lower loan and mortgage repayments, freeing up disposable income to spend on goods and services. This higher consumer spending drives demand, production, and job creation
Reduces Unemployment
- As businesses expand due to lower borrowing costs, they hire more workers, reducing unemployment. More employed people further increase spending, creating a positive feedback loop for economic growth
Weakens the National Currency
- Lower interest rates can lead to depreciation of the national currency because foreign investors seek higher returns elsewhere. A weaker currency makes exports cheaper and more competitive internationally, boosting export-driven growth, though it can raise import costs domestically
Encourages Investment and Stock Market Activity
- Businesses are incentivized to invest more due to cheaper capital. Investors often move money from low-yield savings and bonds into stocks and real estate, driving up asset prices and potentially creating wealth effects that further stimulate spending
Risks and Trade-offs
- If rates stay too low for too long, it can lead to excessive borrowing, inflationary pressures, and the formation of asset bubbles in markets like real estate or stocks. Inflation can erode purchasing power and destabilize the economy if not managed properly
Summary
Lowering central bank interest rates makes borrowing cheaper, which stimulates consumption, investment, and economic growth, while reducing unemployment and weakening the currency to boost exports. However, it requires careful balance to avoid inflation and financial instability. This monetary policy tool is often used during economic slowdowns or recessions to revive growth and support the economy
