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The relationship between interest rates and economic growth is derived from the use of interest rates as a means for achieving desired economic conditions. That is to say that interest rates are tools used to make the economy more stable by limiting undesirable factors like inflation and rabid consumption by consumers. The authority that is vested with the power to make the changes in the rate of the interest in an economy is the central bank of the country under consideration.
Central banks use monetary policies as a means of tinkering with interest rates and economic growth. They usually do this by either increasing or decreasing the rate of the interest on the money that they remit to the other banks in the economy. Economies have cycles that are used as a means of gauging the health of such an economy and any gains that may have been made in the economy by the application of several monetary and fiscal policies. When the parties with vested interest, such as economists, businessmen and businesswomen, the government and the various banks observe the macroeconomic and microeconomic trends after analyzing the periodic economic reports, they will come to various informed conclusions regarding the health of the economy. Where there are unfavorable macroeconomic indicators like rising unemployment and inflation, the central bank might decide to raise the interest rate on the money remitted to the banks.
This action establishes a link between interest rates and economic growth, because the purpose of increasing the interest rates is to address the unfavorable elements in the economy that are detrimental to economic growth. For instance, the action of increasing the interest rates will have a domino effect on the other banks — something that can be likened to a knee-jerk reaction. An increase in the interest rates means that they will tighten their lending policies and also increase the rate of interest they pay on savings deposits. When consumers discover that they cannot have the same easy access to different types of finance for their consumption, they will decrease the rate of such consumption.
Another link between interest rates and economic growth is seen in the way in which the increase in the interest rates will cause the consumers to save their money for two major reasons. The first is to conserve their money due to the perceived scarcity of such finance, and the second is to take advantage of high interest rates offered by the banks as a means of encouraging savings. When this happens, the activity in the economy will decrease, and the rate of inflation will go down as a result. Just the same, when the central bank decreases the interest rates consumers will have easier access to finances, and the rate of consumption will go up, stimulating the economy.
@Logicfest -- the use of Keynes' theories in setting economic policy have always been controversial and remain hot topics for debate. Keynes suggests that the government should step in and control money supply to keep nations from going through "boom" and "bust" periods. The Federal Reserve attempts that through setting interest rates -- keeping them low to encourage credit availability and consumer spending during "bust" times and curbing too much consumption by raising interest rates during "boom" times.
Some have maintained that the Fed's handling of interest rates have not done much good. We still have recessions and you'll find plenty of people to argue that the very existence of those is evidence that Keynes was wrong. Others counter that "boom
" and "bust" periods will be evident in a free market economy and that allowing the Fed to set interest rates in line with Keynes' theories keeps recessions from becoming full bore depressions.
Which side is right? We may never know the answer to that one, but it is good that people are interested enough to debate the topic, huh?
What is fascinating here is how well you've described how central banks in general -- and the United States Federal Reserve Bank in particular -- have implemented economic theories espoused by John Maynard Keynes without actually mentioning the man. This is more evidence that we take Keynes' policies for granted and they are so ingrained in economic theory that they are not viewed as revolutionary as they once were.
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