How Low Interest Rate Affect the Economy?

Lower or Higher interest rates can affect the economy greatly. In some economies, (specially in Europe) We can see that interest rates are quite lower than rest of the world. What is the reason for that? In this short article, I will try to show you the potential benefits of low interest rate to economy.

Who determines interest rate? Interest rates are generally determined by the central banks except some countries. Interest rate can help monetary authorities to organize money supply.
As you know, If money supply increase, prices will increase and If decrease, prices will decrease. Why government should fight against low prices?If you read my Deflation Can't Hurt Us. Really? article, you can also now low prices can cause big problems for the economy. Anyway, for example; If monetary authorities decide to decrease supply of money, they can increase the interest rate to increase deposit funds and reduce borrowing.

Furthermore, If we look at the average interest rate of Euro Area, we can see that interest rate is 0.5%. Almost, zero. Why? As you know, European Union fights  against recession for almost 5 years. Low interest rate can break this recession. How? Let's see.

Spending

Low interest rates mean less savings and more spending. People will not save their money anymore and spend it as consumer which can affect economy positively. Moreover, people can borrow money and buy big purchases such as cars or houses. At the end, more spending means more economic growth.

As seen in the graph, more spending means increase in AD and this will affect GDP positively. However, more spending will increase AD which will increase prices which can cause inflation.

Investment

Another benefit of low interest rate is people and firms can borrow more money Logically, this can cause more investment because people/firms don't have to pay high interest rate. High level of investment can increase employment rate, economic growth and GDP.

Stock Markets

Interest rate can not affect the stock market directly. But, of course, we can make one logical assumption; If Interest Rate decrease, businesses and consumers can spend more and that can cause increase in stock prices. If Interest Rate increase, businesses and consumers will not spend more and that can cause less profit and less stock price.

Exchange Rates

As you know, higher interest rate can increase the foreign demand for the country's currency which can affect exchange rate positively. However, If interest rate is low, it won't attract foreign capital and demand will decrease which can cause lower exchange rate.

Conclusion

I tried to explain everything basically and shortly. Of course, interest rate subject has different perspectives. Lower interest rate can have benefits for some part of the society and can have costs for some. However, nowadays specially in Europe, we see low interest rates (In Sweden even zero) and this has negative and positive effects to the general economy.