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What is the interest rate and how does it affect the economy?

By Lauren AguirreFebruary 28, 2017

U.S. dollar
U.S. dollar Getty Images

In most economics reports and updates, there will be a mention of the interest rate. The national interest rate can have big effects on the economy. What is it and how does it work?

The interest rate, most simply, is the cost someone pays for borrowing another person’s money. If you’ve ever taken out a loan or opened a credit card, you’re familiar with how an interest rate works. In addition to paying back the amount borrowed, the borrower is often also required to pay back a percentage of the total. However, when the headlines refer to the interest rate, they are actually talking about the interest rate the federal government sets on the money it lends.

The federal interest rate, or the federal funds rate, is the one that can move the stock market and is also used to examine the state of the national economy. The federal funds rate for the United States dollar is set by the Federal Reserve Bank, which is commonly referred to as the Fed. Banks pay the federal funds rate when they borrow money from the federal government to insure its deposits.

The Federal Reserve will often adjust the interest rate to control inflation of the money supply. Inflation occurs naturally over time. As time goes on, the general level of prices for goods and services rise. Inflation is why $30 back in 1950 is worth over $300 today. Economically, you could buy more with $1 in 1950 than you can in 2017. Inflation is a common occurrence, but too much of it can ruin the economy. When inflation gets out of control, it is called hyperinflation. Hyperinflation severely devalues currency to the point of it becoming almost worthless. This happened in Germany in the 1920s. During this period, prices doubled almost every four days.

Inflation is a technical way to describe the supply and demand relationship for currency. To make things clearer, think of the U.S. money supply as a product. The Federal Reserve controls the interest rate by buying and selling government-backed securities. To lower the interest rate, the Fed buys a lot of securities. As a result, there is more cash released into the economy. Therefore, demand for U.S. currency is lowered, so interest rates offered by banks and credit card companies are lower too. A lower interest rate is good for borrowers, but a higher interest rate is better for lenders.

Right now, the federal interest rate is being held between .5 and .75 percent. It was lowered to this level around the time of the 2008 financial crisis. The Federal Reserve has kept it low ever since. Some economists are afraid that a higher interest rate would end up slowing the still-recovering economy.