If you are a follower of the economic press, one of items of news that has had more impact these days is the decision by the monetary authorities of both the United States and Europe to reduce the interest rate of money or announce future reductions in their respective areas of action.
The question is, do these movements of high economic spheres really affect ordinary citizens? Do they have an influence on our day-to-day economy? The answer, although we don’t believe it, is yes, especially if we are small entrepreneurs.
How changes in interest rates affect us
When a Central Bank lowers the interest rate of money, what it is doing is lowering the price of money. Because, indeed, money has a price, the interest that central banks charge to commercial banks for lending them money. And yes, commercial banks are the ones who lend money to us. We start to see the relationship, right?
A reduction in interest rates of money what it does is to encourage banks to lend money more easily, less interest or in greater quantity. Obviously, Bank A can try to take advantage and continue to maintain high interests to get more profit. However, we as consumers, very skillfully, would go to Bank B to request a loan, which has lowered their interests, so that Bank A will have no choice but to lower their loans as well. It is the magic of competition.
Thus, we see what is the main impact for the average citizen (including the small business owner) of these maneuvers of the big economic spheres. If I am an entrepreneur, a drop in interest rates means that I will be able to undertake investment and expansion projects because I will have easier access to external financing and also my clients will have access to consumer loans, so my chances to sell increase.
So, if the effect of lowering interest rates is so good for the economy, why aren’t central banks always keeping them low? There are two reasons against this.
On the one hand, the economy, the markets, or whatever we want to call them, are a bit like people, they get bored of the same. And if we carry out the same economic measures for a long time, they end up having no effect.
But the most important thing is that, if the interest rates of money are kept very low for a long time, you run the risk of encountering one of the economic effects that you are most afraid of today, which is inflation. Indeed, if we have a cheap money environment, it tends to consume a lot and that makes prices rise. And central banks panic that prices rise too much. The point is that it is not good that they don’t climb too much, the economy is like everything, nothing is good in excess. There is really no clear idea of how much inflation is “good” (it is clearer how much is “bad”) or at least you do not have the same idea throughout history, but today in Europe, for example, inflation is expected to move around 2% per year.
In short, monetary authorities try to find a balance between a price of money that helps the economy, but not “hot” too much. Interest rates tend to be lowered when there is an economic recession or it is guessed that there will be one, and it tends to be raised when it is detected that the economy is in danger of entering an escalation in price increases.
Obviously this is a very simple explanation for a very complicated subject with countless economic literature behind. But at least we hope it helps to understand certain news that we encounter on a daily basis.