The Fed, Interest Rates, and Market Clearing Prices
The Federal Reserve holds the power to regulate monetary policy in the United States, perhaps most notably the ability to raise and lower interest rates according to the state of the economy. A recent Fortune.com article details how, in recent years, the Federal Reserve has kept interest rates at an all time low between zero and a quarter of a percent, as a way of boosting the economy after the financial crisis of 2009. Theoretically, by lowering interest rates, consumers will be incentivized to spend their money instead of stashing it away in bank accounts, or take advantage of low rates to take out loans to finance investment and spending. This increased spending then stimulates the economy, allowing for markets to recover and increased consumer confidence, which in turn encourages a positive cycle of further spending and recovery.
However, in the grips of a poor economy, the Federal Reserve has to make sure interests rates are low enough that it benefits consumers more to spend than save. This situation is very similar to the market clearing price problems we studied in class, but instead of raising prices until buyers reach the threshold at which they are unwilling to spend further, we lower interest rates until consumers are unwilling to save further. Alternately, in cases of an economy where there is an excess supply of money, the Federal Reserve would raise interest rates until consumers find it more beneficial to save money in the bank than to continue spending. Just like in market clearing price problems, when there is too much or too little demand from buyers, you can raise or lower prices in order to manipulate buyers into acting as you want them to. The Federal Reserve simply does this with interest rates instead of prices.
The article goes on to describe a proposal by former Federal Reserve Chairman Ben Bernanke to lower interest rates further, creating “negative interest rates”. As current rates are already near zero, if the economy suddenly plunged the Federal Reserve would have nowhere left to go. Dropping interest rates below zero creates an extreme stimulus in the economy, essentially forcing consumers to go out and spend, as they would otherwise be losing money. For example, a negative 2% interest rate would result in a person depositing $100 in the bank and being credited with only $98. Interestingly, this idea of negative rates actually goes against the rule in market clearing prices, which says that if a price reaches zero, you stop and do not decrease it further.
Source: http://fortune.com/2015/10/21/bernanke-negative-rates/