interest-rates, austrianI’ve heard of Austrian school which seems interesting. Among other things, they argue that the federal reserve keeping interest rates close to 0% is bad for the economy.
Let us start with the Fisher Rule, from the 20th Century economist Irving Fisher, that states that $i_t=r_t + \pi^e_t$, i.e. the nominal interest rates (this is the central bank’s instrument) is determined as the sum of a real interest rate and an expectation for future inflation. The real interest rate at time $t$, $r_t$ is simply the opportunity cost of capital.
Central banks use monetary policy to influence the performance of the macroeconomy in the short run. If a central bank lowers nominal interest ($i$) rates too much then it encounters the zero-bound problem, whereby nominal interest rates ($i$) cannot be lower than 0. Because of this, the central bank can be forced into non-orthodox measure such as Quantitative Easing and other large-scale asset purchases. In Europe, to lower the rates that sovereigns pay on their public debt, the European Central Bank is now buying up bonds. By adding to the weak demand for public debt in Europe, it hopes to increase prices and thereby lower interest rates. Remember that because these bonds are sold at discount (below par), there is an inverse relationship between the price and the interest rate.
A low real interest rate ($r_t$) will cause overindebtedness, leverage and speculative bubbles. According to many economists such as Robert Shiller (author of Irrational Exuberance), it was precisely due to a period of very low interest rates following the tech bust that the US housing boom was born. Also, in Europe, because of the euro which lowered real interest rates in many countries, a binge followed. Now many countries there (namely the PIGS, i.e, Portugal, Italy, Greece and Spain) are forced to deleverage, i.e. to lower their levels of debt. Austerity measures are underway precisely to reduce excessive levels of public and private indebtedness.
There are many explanations to this. One of them is that when domestic interest rates are low, foreigners are not willing to invest into the US economy, reducing demand for the USD. Cheap USD means imported goods will cost more to americans. I’m not sure if that’s what Austrian economists believe though.
You own a bank. How would set the interest rate for customers who want to borrow money? One of the factors would be how much money your bank has available to lend. If you have a substantial amount of reserves (i.e. customers making deposits by saving money) then you would charge a lower interest rate. The interest rate depends on how much people save. People have to save money first before anyone is able to borrow money. Another factor is the demand for loans from customers. When a lot of customers start requesting loans you will raise your rate. Thus, the interest rate is the price of borrowing money where the price is determined by supply and demand: supply being savings and demand being the amount of customers demanding loans.
This is how the interest rate is determined in a free market. Having an entity, such as the FED, arbitrarily set interest rates distorts the free market price mechanism for borrowing. The interest rate is usually set artificially low to stimulate the economy. This causes people to take loans that would have not been possible in a free market system. This temporarily increases economic activity as people spend the borrowed money. But this is not sustainable since the interest rate was not set by the market. The low interest rate was artificial and gave the illusion of savings. The bust occurs when the borrowing starts to slow at the given rate.
The FED controls the interest rate through two main factors: the reserve ratio and the federal funds rate. The FED specifies the minimum amount of reserves a bank must have on hand. Banks can loan money until they hit the reserve ratio. The federal funds rate is the overnight interest rate at which member banks can borrow from the FED.
I agree with the other poster who suggested reading a college economics textbook first. After that thoroughly confuses you then read about Austrian economics which explains the above. Here are some starters: Economics in One Lesson, How an economy grows.
All content is licensed under CC BY-SA 3.0.