I am not an economist, but if you think of prices in terms of supply and demand, then when there is more demand, prices go up.
When the interest rate is super low, there isn’t much incentive to save money, so consumers spend more, and business take out loans to do more stuff. All of that creates more demand.
When the interest rate is higher, consumers tend to save more money, and businesses are hesitant to take out those loans to expand. All of that decreases demand.
But wouldn’t the volume of spending make up for that with lower interest rates? Meaning, people are already hurting, why should the consumer be the one facing the storm. It seems like businesses raised prices during covid and just kept going. Does the interest rates stop them from raising prices?
There is this funky thing with loaned money that’s a little hard to explain. Loaned money is an economic amplifier. While interest rates adjustments do effect the consumer, the primary target for them is actually banks and businesses.
So when a loan is given it essentially doubles the amount of money in circulation. This is because the lender records the loan as an asset in their books and then the debtor takes that loan and has funds for spending, pushing that money into the economy. So if a bank gives a loan to a big company and that company then gives another big loan using that money to some other third party then the original loan amount triples or something and all of that money is effectively entered into the economic pool.
The average person thinks of this debt in terms of just money for buying physical assets like a car or a house. But that’s not right at the level of the Fed.
See, The Fed sets rates high to help stop things like banks from issues dubious loans or big companies taking on more debt to invest in stocks. I know this isn’t ELI5 but corporate finance is complicated.
The simple answer is that the fed isn’t as concerned with individual loans. Those lending amounts are a drop in the bucket compared to banking and corporate loans. Setting rates higher will effect average people’s loans, but that’s at the end of the domino chain. This is a proven method to help slow inflation because when rates are low, banks and companies are using debt to buy more and buying more drives inflation.
in a healthy economy that’s based on the exchange of goods what you’re thinking might be right, but our economy runs on theoretical values, and on debt. Raising interest rates does a lot of things.
Do I think it will stop businesses from raising prices? no.
Should it? yes, based on sound economic theory it should. It won’t, because ‘number must go up’ and most major businesses have stopped practicing consumer based economics. but raising rates will slow the price increases which is really what you want.
edit: This was a bad explanation and I’m sorry. corporate finance is a bunch of bullshit. my actually ELI5 would be that this is to stop BANKS and CORPs from taking loans. not people. Higher interest rates mean that they won’t be as risky with their investing because there would be less reward in immediate access to funds.
Actually, you make a great point about how loans work, and it makes even more sense when you realize that banks only need to keep a portion of their deposits in the bank. So making loans really does create money out of thin air.
I am not an economist, but if you think of prices in terms of supply and demand, then when there is more demand, prices go up.
When the interest rate is super low, there isn’t much incentive to save money, so consumers spend more, and business take out loans to do more stuff. All of that creates more demand.
When the interest rate is higher, consumers tend to save more money, and businesses are hesitant to take out those loans to expand. All of that decreases demand.
But wouldn’t the volume of spending make up for that with lower interest rates? Meaning, people are already hurting, why should the consumer be the one facing the storm. It seems like businesses raised prices during covid and just kept going. Does the interest rates stop them from raising prices?
There is this funky thing with loaned money that’s a little hard to explain. Loaned money is an economic amplifier. While interest rates adjustments do effect the consumer, the primary target for them is actually banks and businesses.
So when a loan is given it essentially doubles the amount of money in circulation. This is because the lender records the loan as an asset in their books and then the debtor takes that loan and has funds for spending, pushing that money into the economy. So if a bank gives a loan to a big company and that company then gives another big loan using that money to some other third party then the original loan amount triples or something and all of that money is effectively entered into the economic pool.
The average person thinks of this debt in terms of just money for buying physical assets like a car or a house. But that’s not right at the level of the Fed.
See, The Fed sets rates high to help stop things like banks from issues dubious loans or big companies taking on more debt to invest in stocks. I know this isn’t ELI5 but corporate finance is complicated.
The simple answer is that the fed isn’t as concerned with individual loans. Those lending amounts are a drop in the bucket compared to banking and corporate loans. Setting rates higher will effect average people’s loans, but that’s at the end of the domino chain. This is a proven method to help slow inflation because when rates are low, banks and companies are using debt to buy more and buying more drives inflation.
in a healthy economy that’s based on the exchange of goods what you’re thinking might be right, but our economy runs on theoretical values, and on debt. Raising interest rates does a lot of things.
Do I think it will stop businesses from raising prices? no. Should it? yes, based on sound economic theory it should. It won’t, because ‘number must go up’ and most major businesses have stopped practicing consumer based economics. but raising rates will slow the price increases which is really what you want.
edit: This was a bad explanation and I’m sorry. corporate finance is a bunch of bullshit. my actually ELI5 would be that this is to stop BANKS and CORPs from taking loans. not people. Higher interest rates mean that they won’t be as risky with their investing because there would be less reward in immediate access to funds.
Actually, you make a great point about how loans work, and it makes even more sense when you realize that banks only need to keep a portion of their deposits in the bank. So making loans really does create money out of thin air.
Thank you so much, you explained it really well so I could understand. It’s putting a leash on the lenders.
Edit on your edit: No, you did a great job. I get it now.