How do low interest rates affect the economy?

In a capitalist system, interest rates are critical to how the economy functions. The Federal Reserve is charged with adjusting rates to keep the economy running smoothly, and also to keep inflation from getting out of control. When interest rates are high, the economy slows. When interest rates are low, borrowing is easy and economic activity is encouraged. In this article, find out how low interest rates affect the economy.

How are interest rates derived?

The Federal Reserve sets a target rate - the Federal Funds rate - for overnight lending among banks, which smooths out the banking process. The prime rate, which is the lowest interest rate that banks charge to their best, most creditworthy customers, is usually three percentage points over the Federal Funds rate. Consumer rates Consumer annual percentage rates (APR) are normally a couple of percentage points higher than the prime rate. Auto loans and home mortgages are based on the prime rate. Qualifying for loans Just because interest rates are low, it doesn't necessarily follow that everyone will borrow money and spend it. The consumer has to qualify for a loan before he can get the low interest rate. Credit cards, which almost everyone has, often come with very high interest rates, even when the prime rate is low. On the other hand, sometimes car manufacturers offer low interest loans to spur their business.

The situation today

As of 1 August 2011, the Federal Funds rate is nearly zero. Yet, economic activity is weak. The housing bubble leading up to the crash of 2008 After the tech bubble burst in 2000, the Federal Reserve lowered interest rates and kept them low for many years. The United States' housing market heated up, and eventually, even with interest rates creeping up, the market spun out of control. This happened because virtually everyone could get a mortgage. The result was that a lot of people got loans, including those who were not really qualified. In the end, many of these people defaulted. The crash of 2008 Eventually, the housing market overheated and collapsed. Prices tumbled, and in response, the Federal Reserve lowered rates to an unprecedented 0.25 %. Mortgage rates also tumbled, but the banks, having taken a terrible beating in the previous couple of years, tightened qualifications so that few people could get a loan. 2011 Currently, mortgage and other interest rates are low, but it is very hard to qualify for a low APR loan. Those loans that are available, such as credit cards, carry high interest rates not connected to the prime rate. On the other hand, large companies can borrow at low rates, and they are doing well.