An interest rate can most easily be thought of as the "price of money." Thus, when interest rates are low, money is "cheap," and it is easier to borrow to start new projects. When interest rates as high, money is "expensive," and it is harder to borrow to start new projects.

Interest rates would exist absent of any form of central bank. Just as prices would exist in a perfectly free market, so would interest rates, as, again, interest rates are essentially just the price of money.

In a natural free market, an interest rate is determined by how much money people save or invest vs. how much they spend. It is generally thought that people prefer present goods to future goods. For example, if I could have an Xbox 360 either now or in a month, I would rather go ahead and have it now, as that is an entire extra month that I would have the Xbox 360. So, the signal being sent when people save a lot of their money is that there is something in the future that they want to purchase that they value more than anything that they could purchase at the moment. People also will save there money is if there is a good that they want in the present, but cannot afford. Still, the present goods vs. future goods rule holds, because this action of saving money on the part of an individual shows that they would prefer having this expensive good in the future over having a good that they could afford in the present.[1]

Interest Rates and Economic Growth

As stated before, low interest rates tend to lead to growth, as it is easier to borrow money and begin new projects when money is "cheap." Not only do low interest rates make it easier to borrow, but they also give banks a greater incentive to lend. This is because the natural cause of low interest rates, lots of money being saved in banks, means that banks have extra money on reserve. They will use this extra money to seek extra profits.

Banks make their profits by lending out money. The more money they have, the more money they can lend. More lending stimulates economic growth and generally leads to more market entry, increased competition, lower prices for consumers, and an increase in the general standard of living. However, a key point to note is that there is a natural cause of low interest rates -- a high investment rate.

To sum up, there are two primary reasons that low interest rates stimulate economic growth:

  1. Low interest rates increase the incentive for banks to lend money
  2. An interest rate, like a price, is an economic signal, and a low interest rate signals that investors plan to spend their money in the future, not the present, telling entrepreneurs that they can produce a lot now and they will be able to sell it in the future.

Interest Rate Manipulation by the Fed

The Federal Reserve uses its money supply manipulation powers to increase the amount of currency in the banking system. While it is often said that the Fed "prints money," the reality is that most of the money that the Fed puts into the banking system is digital money in the form of zeros and ones in a computer. The Fed has a target interest rate called the Federal Funds Rate, which is supposed to be a safe interest rate that is low enough to stimulate growth but high enough to maintain the value of the dollar. The idea is that when the Fed adds currency to the economy, it will stimulate borrowing and lending, thus stimulating economic growth. This is the "boom" part of the boom-bust cycle.

The boom can last for some time. Interest rates were held extremely low during the majority of the 2000's until the economic collapse of 2008. However, eventually the natural interest rate will break through the Fed's manipulation. This is because money cannot be added to the economy forever. If money is constantly added, the currency will eventually be destroyed, as was seen in Wiemar Germany during the years between World War I and World War II.

At the end of the day, the natural cause of low interest rates, a high investment rate, never occurred. If there was no investment, that means that people never actually preferred future goods over present goods to the extent that entrepreneurs believed. All the signals being sent were false. Investments either cannot be sold, or were sold to people who could not in fact afford to maintain them. This also means that a lot of money was lent to people who cannot pay it back. The result is an economic collapse -- the "bust."
  1. ^ Chapter 6 "Production: The Rate of Interest and Its Determination" in Rothbard, M. N. (2004), Man, Economy, and State, A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, pp. 367.