The practice of cutting interest rates is something that just about every country has done from time to time. While some people believe that the action of cutting interest rates is always a good thing, that is not necessarily the case. While reducing interest rates can certainly have beneficial effects for some portions of the economy, there is also the potential to damage other sectors. Here are some examples of when cutting interest rates can be helpful and when the action could lead to economic difficulties for a given country.
One of the immediate benefits of cutting interest rates is that the action can stimulate consumers to purchase more in the way or property, goods, and services. Because interest rates are lower, the typical consumer perceives some larger purchases to be more affordable, since the purchase will ultimately include a lower amount of financing in the final price. People are more receptive to applying for credit to finance big ticket items such as a home or a new vehicle. Even consumers who are not in the market for a major purchase tend to use credit cards with a little more abandon. From this perspective, cutting the interest rate is a great way to stimulate a sluggish economy, and get people into the stores once again.
At the same time, cutting interest rates can have some devastating consequences on the back end. Interest revenue helps to maintain the operation of many financial institutions. When the interest rate is cut, that means the income to those institutions is also reduced. Depending on the current economic climate, this can lead to cutbacks that may include discontinuing services to consumers, as well as job cuts. With more people out of work, there is less disposable income to circulate through the economy. When interest rates are cut during a period of inflation, this can often lead to an increase in the problem rather than reduce it.
Governments often consider the reduction of interest rates periodically, including in times of recession. In the United States, the Federal Reserve will often lead the way in implementing the reduction. The decrease in interest rate is normally announced by the Federal Reserve Bank system and all affiliated banks immediately implement the change. At the same time, the Fed will also be the instrument whereby interest rates are increased, if the government determines that is in the best overall interests of the economy.
Cutting interest rates is often portrayed as both desirable and an action that has little in the way of long term consequences. While there are certainly situations in which reducing the current rate of interest is helpful to the economy, it should never be viewed as a quick and simple fix that will not have some consequences at the end of the day.