When growth and inflation are at low levels, central banks and governments can use various methods to stimulate the economy to increase inflation, increase spending, and increase employment. Here are some of the strategies that can be undertaken to achieve economy growth.
Lowering Interest Rates
When the central bank lowers the interest rate, it wants to change the behaviour of borrowers and lenders by making loans cheaper for individuals and businesses. The Reserve Banks of Australia (RBA) has the goal to keep inflation within a certain level. When the economy is not at these benchmarks, they may adjust the interest rate to stimulate or slow down the economy. The Australian economy has been showing low inflation at one and a half per cent, but the target is two to three percent. The purpose of lowering the interest rates is to encourage businesses to borrow money to invest and grow, and for consumers to spend money to grow the economy.
This means increasing money supply in the economy by purchasing bonds from banks. Governments do this by printing out money and then buying government treasuries from financial institutions. Governments choose to do this because lowering interest rates has not been effective in stimulating the economy. When governments keep cutting interest rates lower and lower and growth is still low, they need to think of alternative ways to stimulate the economy. The central bank is trying to increase the money supply for consumers in the anticipation they will then spend money on goods and services. When banks sell bonds to the central bank, they should have increased cash reserves and this should encourage them to lend out money to businesses. Banks need to hold a certain amount in their cash reserves each night. With quantitative easing, this adds to the cash reserves which should encourage banks to lend to the customers. The central bank is using this strategy encourage customers to spend by lending them money and they are encouraging businesses to expand by lending them money.
Negative Interest Rates
Negative interest rates do not happen often but when other strategies do not work, then central banks may resort to this. The purpose of negative interest rates is to discourage savings and encourage borrowing. Borrowers are discouraged to save as banks charge these depositors a penalty if they keep their capital in cash. In times of weak economic confidence, individuals and businesses are compelled to hoard money which exacerbates economic instability.
The risks of lowering interest rates
Highly indebted households – The era of low interest rates has caused household to be highly leveraged. Low interest rates can cause asset bubbles. This occurs as investors bid up the price of an asset as credit has become so readily available but prices may not reflect the fundamental value of the asset.
Increases inequality- Wealthier people benefit the most from low interest rates as individuals with assets will see their net worth increase as their shares and property go up in value. This is bad news for people who do not have assets and are trying to obtain them as they will see higher entry prices.
Lauren Hua is a private client adviser at Fairmont Equities.
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