The Federal Reserve and Interest Rates

Question - During the current recession, interest rates have been held at historically low rates by the Fed. They use the Keynesian argument that low interest rates "keep credit flowing freely." But it seems to me that the lower interest rates are, the less incentive banks have to give out loans. If this is correct, why is raising the interest rate (or at least leaving it alone) not the answer to getting credit flowing again?

Response - First, it is important to understand precisely what interest rates are. Interest rates are the price for borrowed money. However, this particular price works a little differently from the prices we encounter most frequently (for example, the price on a can of green beans at Wal-Mart, or the price of a gallon of petroleum at the gas station). Prices help allocate resources more efficiently by providing incentives for resources to flow from where they are plentiful to where they are scarce (from where prices are lowest to where prices are highest). As more goods flow in this manner, the price level begins to even out between the two locations.

Interest rates, however, help allocate resources more efficiently by providing incentives for resources to flow from one time period to another. The higher the interest rate, the more it pays to forego spending now in order to spend more in the future - so resources flow from the present into the future. The lower the interest rate, the more it pays to forego saving now in order to spend more now - so resources flow from the future into the present.

Let us assume that I am currently indifferent between $100 right now and $105 one year from now. My effective interest rate is 5%. In order to convince me to part with my $100 right now, you must offer me (at the very least) $105 a year from now. If, however, the majority of potential lenders is indifferent between $100 right now and $107 one year from now, the effective interest rate will be 7%. This is great from my point of view, because I was willing to lend at 5%. If I can get 7%, why should I settle for 5%, right?

This is how interest rates work. The Federal Reserve System does not set interest rates. The Federal Reserve System sets only the rate at which it charges banks for borrowing money from the Federal Reserve. Banks have the ability to borrow this money and then loan it out at interest. If the target rate set by the Federal Reserve is 2%, then the banks have to charge more than 2% interest when loaning out this money to borrowers in order to earn money. In this way, the Federal Reserve indirectly influences the overall interest rate offered by the banks.

However, it takes two to make an interest rate work. If I do not receive an offer of at least 5% (since I am indifferent between $100 now and $105 a year from now), then I will not be willing to part with my cash. I must receive a payment that satisfies the inconvenience of no longer having the cash in my possession as well as the risk I am taking that the loan will never be repaid. If I am not paid for this risk and inconvenience, then I will have no incentive to loan you my money.

Now, to your specific question. Why is raising the interest rate (or at least leaving it alone) not the answer to getting credit flowing again?

The higher the rate is that the Federal Reserve charges the banks for borrowed money, the higher the rate they will need to charge borrowers in order to make money. The higher the interest rate the banks charge potential borrowers, the fewer people will be willing to borrow. In this way, interest rates work just like every other price in the market. The higher the price (interest rate), the lower the quantity (of loans) demanded and the higher the quantity (of loans) supplied - at that price. The lower the price (interest rate), the higher the quantity (of loans) demanded and the lower the quantity (of loans) supplied - at that price. All other things being equal, of course.

Does this answer your question? Please feel free to ask any follow-up or clarifying questions you feel are necessary.