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The Two Sides of ZIRP

Aug 23, 2010 • Economic Debates, Money and Monetary Policy • 96 Views    1 Comment

Hearing economists discuss the Fed’s zero-interest-rate policy, Harry Truman would again search for a one-handed economist.

On the one hand…if you can borrow money cheaply, you are more likely to expand your business and buy a house or a car. Especially during a recession, low interest rates can encourage business expansion and consumer loans. As a source of economic stimulus, many believe that zirp is desirable.

On the other hand…households and businesses that have income based on interest rates are suffering. Historically, savers have been able to earn an average of 3 percent. Now, they receive close to 0% when they invest in such financial instruments as short term treasury securities, The problem? If we look at what they could have earned, savers have lost a total of $350 billion annually–350 billion that would have been saved or spent.

For countries also, there are two sides. According to the Bank for International Settlements (BIS), countries with zirp, such as the U.S., can borrow money very cheaply. Also though, other nations such as Australia that pay higher interest rates, can lure investors away from lower yielding securities elsewhere.

The Economic Lesson

The interest rate is the price of money. When an economy experiences rapidly rising prices, central banks usually increase the price of money to constrain spending. Recession, by contrast, requires a lower price of money (interest rate) in order to stimulate business and consumerr spending. 

The Federal Reserve has three traditional tools to affect interest rates in the U.S. 1) It can change the amount of money that banks have to keep in reserve. 2) It can change the interest rate that it charges banks when they borrow the Fed’s money. 3) It can enable banks to have less to lend by selling them securities or more money to lend by buying securities from banks.

During the recent recession, the Federal Reserve expanded the contents of its monetary policy “toolbox”.

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  • EmilyMiller

    I think it is very powerful how the Fed can just adopt a new “tool” to dramatically alter the economy of the United States and the livelihood of about 300 million people. This is an interesting post as it shows both sides of low interest rates. I find it interesting that the people who save their money and act frugally and invest smart are the ones who are now suffering.

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