Low interest rates are often seen as a panacea to many economic ills, but every economic policy has its drawbacks. Low interest rates are no exception. While it’s easy to understand the advantages that come with low rates and their ability to stimulate spending, many economists also see macroeconomic advantages to high interest rates — so don’t immediately think we’re heading to an economic crisis the next time you hear that the Fed boosted rates.
Savings and Savings Income
It’s hard to justify putting your hard-earned money in the bank when it earns a measly return on your investment. When interest rates are high, your incentive to save is much more obvious, as interest payments sweeten the deal when compared to purchasing new goods. On an economy-wide basis, this also increases savers’ annual income, as high interest rates also contribute more to family income by increasing the amount investors receive in interest each year.
Increased Risk Aversion
When interest rates are low, investors look to unusual means to help generate investment income. While this quest for improved returns can lead to innovation and growth, it also leads investors to purchase more high-risk investments to keep their income flowing. When interest rates are high, returns on normal savings provide a buffer against riskier investments, as investors don’t need to seek out volatile investments to continue to reap rewards from their investment. This environment can lead to less volatility in the market, with more investors content to play it safe with typical rates of return.
Bond Debt Retires
Government agencies often raise funds by issuing bonds that are guaranteed to pay a stated rate of return, which is typically governed by the market. When interest rates rise after bonds are issued, it makes holding the bonds less attractive to investors who can place their money in areas with a better return. Because of this, many governments can buy back bond debt easily after interest rates increase. This allows municipalities to retire debt, freeing up money in their budgets to devote to other projects.
Lower Commodity Prices
Producers of commodities such as steel, coal and other energy have a larger incentive to produce more when interest rates are high: Any profits they glean during eras of high rates can be reinvested for a return. Because of this, commodity prices fall as producers of these goods create as much as possible, increasing supply of their products.
Stable Retirement Plans
If your job offers you a fixed-benefit retirement plan as part of your compensation package, it’s nice to know that the investment isn’t going to default before you reach retirement age. High interest rates can help ensure that: Because investments finance these plans, higher interest rates means higher rates of returns on the plan’s investments, which in turn provides the plans with the cash it needs to meet its obligation to pensioners.
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