Most people think that they understand interest rates, when in reality they do not. The interest rates you receive at a bank is more than just a number. They are extremely important, and without interest rates our economy would be more of a roller coaster than it already is. In economic terms, the interest rate is the cost of holding money.

Now your probably thinking…”It doesn’t cost me anything to hold my money! Look its here in my wallet safe and sound!”

WRONG!

Because the money is in your wallet, it is not in your bank account. That means it is not earning interest. You are willingly sacrificing that interest to hold the money in your wallet. Now, this isn’t a big deal when interest rates are 1%, but if interest rates are higher, people will think twice about making big investments or loans.

Putting it All Together

Interest rates pay an important role in controlling the economy. The Fed can turn interest rates up or down in order to control the amount of money invested. By turning interest rates up, they slow investment because the opportunity cost of not investing shrinks. Confused? Let me try an example.

Suppose you are an investor who has 100000 dollars and a yearly return on investment of 15%. These investments are relatively safe but there is a chance of failure. Also suppose that banks are paying 3% interest on a high yield savings account. This means that in one year, you would make 15000 dollars investing or 3000 dollars from the savings account.

That difference of 12000 dollars is enough to make most people risk their money investing.

However, what if the Fed wanted to slow down investing and raised interest rates to 8%? Then the savings account would net you 8000 dollars, while your investments still only net you 15000. Now the difference between the two is only 7000 dollars. Less people would be willing to invest at this new, higher interest rate. The opposite is said to be true when the Fed decreases interest rates.

Why Would the Fed Want to Slow the Economy Down?

The most basic answer is to control inflation and market cycles. When an economy is left alone during good times, money can move around so fast that inflation becomes an issue. In this case, raising interest rates can help keep money in bank accounts instead of being spent.

Why isn’t Obama’s Spending Spree Causing Inflation?

Normally, such an influx of money would cause severe inflation. However, in this case although money is being pumped into the economy it isn’t moving around. Most people are using the extra money to pay off thier loans and bills instead of spending it on goods. This means that the money from the stimulus package went straight back to the banks. The inflation is still there but it is on hold. This concept is what economists call the velocity of money. Don’t worry inflationists your time will come.