Economics Made Economical

Why Doesn’t The Fed Set The Interest Rate To Zero?

If lowering the interest rate is one of the best ways to expand our economy, shouldn’t the Fed just set the interest rate to zero or even negative to keep the economy growing?

It’s not that simple. Obviously the answer is no. But why?

A prolonged period of low interest rates means that nobody wants to invest money for future growth. They want to spend it all now before inflation begins to cut the money’s real worth. Many once-prosperous economies around the world–one of the most extreme examples recently being Zimbabwe–have fallen into this trap. When people are spending money as fast as they bring it in, there’s nothing to prevent the people who are selling the goods from raising their prices. Ideally, it’s only gradual, such as in the U.S. where annual inflation is typically around 2%.

But if it’s allowed to continue unabated, giving people absolutely no incentive to hold off on spending all of their money, hyperinflation could result, as it has in Zimbabwe. Their inflation rate is over 1,000,000%. Something that costs $1 in Zimbabwe today will cost $10,000 next June. And we thought we had problems!

With high inflation and expansion, prices will rise. Employers may have to fight for employees because the unemployment rate could actually become negative. Therefore employers will have to consistently increase their employees’ pay. However the employers and employees alike are also being forced to pay higher prices for all purchases they make.

Higher prices leads to higher pay which leads to even higher prices, etc, etc, etc, and it’s not difficult to see how hyperinflation could ensue. If I made $10,000 today and knew it would only be worth $1 in 365 days, I’d rush to spend it all as quickly as possible. Unfortunately for many in Zimbabwe, by time what little pay they make has gotten from their place of employment to wherever they intend to spend it, it’s usually already worth too little to buy what they thought they’d be able to buy.

When inflation begins to get out of control, the Fed raises the interest rate to try to encourage more people to save. The key to making the U.S. economy successful is this constant monitoring to keep the interest rate in a balanced state.




    1. The Glossary, Part II: Fiscal Policy vs. Monetary Policy « econprofessor
    2. What Is Deflation? « econprofessor

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