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Interest Rates

Interest Rates

Author: Kate Eskra

Determine the effects of interest rates on the economy.

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Source: Image of Money Market graph created by Kate Eskra, Images of Expansionary and Contractionary Monetary Policy created by Kate Eskra, Image of Government Impact on Money Market created by Kate Eskra

Video Transcription

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Hi, welcome to Macroeconomics. This is Kate. This tutorial is on interest rates. As always, my key terms are in red and my examples are in green.

In this tutorial, we'll talk about how the government finances expansionary fiscal policy. And you'll understand how deficits incurred to finance this expansionary policy can actually impact interest rates in an economy.

So let's start out with a reminder as to what fiscal policy is. It's typically policy set by a central government authority where spending by the government is adjusted to stabilize economic activity. So there are actually two tools of fiscal policy, government spending and taxation. And so fiscal policy looks at the policies in these two areas. The goal is for the government to use taxation and government spending to stabilize our economy's movement through business cycles.

So the problem is we have short and long goals here. In the short-term, the goals are of full employment and price stability. So the government's going to use taxation and spending to stabilize the economy when either unemployment or inflation rises.

In the long though, we want to make sure that our economy is growing over time. So here's your definition for economic growth. It's the measure of change in real GDP over periods of time. It's usually expressed as a percent change. And so it's a percent change in value of all the goods and services produced in a country's borders over a specified time interval.

So the big idea is that our short-term fiscal policy decisions can actually end up impacting our long-term ability to achieve economic growth. And that's all because of its impact on our national debt.

So without increasing taxes-- because if we end up increasing taxes to finance expansionary fiscal policy, that'll be counterproductive because that's taking money away from people. So without increasing taxes then, the government has to borrow money by selling treasury securities to finance the increased government spending needed at the time to stimulate the economy. And so they take on debt.

To increase demand and stimulate the economy in the short-term, the government has to spend more money than they collect in taxes. They either have to increase their government spending or collect fewer taxes or both in order to pump money into the economy and get people spending again.

And so when these government expenditures exceed tax revenue, that's what expansionary fiscal policy is. But that's also known as a deficit. Deficits are shortages that result from spending in excess of revenue.

So when the government borrows money to finance expansionary policy, in the future then they have to either repay with tax revenue or with new debt. Let's talk about the situation when they roll over their debt and use new debt to pay off previous debt.

The idea is that at the very least they have to pay interest to service the debt. So here's a really long definition of interest for you. There are a lot of different ways that we can look at interest. The first way that we're going to look at interest, I'm going to show you on the next slide a graph of the money market. And really we'll just be kind of talking about how interest is the cost of money.

There's a difference between nominal and real interest rates. So you can read that part of this. There's also the idea is that it's a return on investment. And we'll be talking about that later in the tutorial. So all of this definition is a way of looking at how we can define interest.

So the interest rate is the price of money, or the cost of money. Because if you think about it, if I choose to hold my money right now as cash or if I choose to go out and buy something with it, what is my opportunity cost of that decision? It's the fact that I'm sacrificing the ability to earn interest on that money. So that's the first way that we'll think about this.

If we look at the money market, and we have supply and demand for money, what we do is we put price on the y-axis. Well, the price here, or the cost of money itself, is the nominal interest rate. The quantity of money goes on the x-axis. We've assume that the Fed controls the supply of money. So that's why it's a vertical straight up and down line. So it's fixed.

But the demand for money does vary with interest rates. Let's think about this. When interest rates are higher, wouldn't you rather, if you could, keep your money in the bank instead of spending it? Because you're earning a higher interest rate on it. Plus, it's more expensive to take out loans. So you don't want to do that as much.

As rates fall, it's not worth it to really keep it in the bank as much. And now it's more attractive to take out loans for home, a car, et cetera, because rates are lower. So that's about that.

These are two graphs that show that the Federal Reserve has a direct impact on interest rates, or can. What they can do is change the money supply. That's what our fed has power over. So this is expansionary monetary policy. And this is contractionary monetary policy, where they're lessening the money supply.

Remember, they can change the money supply through their tools of open market operations, the reserve requirement, and then targeting rates. So just notice on these two graphs-- we're going to come back to this at the end of the tutorial-- how they can have an impact on interest rates by changing the money supply.

Well, back to government with fiscal policy, the government cannot directly influence the money supply. But fiscal policy actions can indirectly impact this money market. Because the big idea in this tutorial is the idea that when the government needs to borrow money to finance expansionary policy, they now enter the private market for loanable funds. They're becoming someone else demanding a loan.

So, no, they're not shifting the money supply as the Fed can. They are becoming additional demand for borrowing money. So when we increase the demand for loans, you can see the impact is that it drives up interest rates.

Now, something to keep in mind is that very often, when the government is enacting expansionary fiscal policy, the Fed will often do the same and use expansionary monetary policy by either buying treasuries or trying to target lower rates. So they can do those things at the same time. And when we increase the money supply, you can see on this graph what's the impact of that. That effect is to drive rates down so this can really offset the impact of the government demanding loans if they're also acting expansionary monetary policy.

And this is the way that we can explain what happened during the recession that followed the housing crisis. Because you would have expected rates to skyrocket as the government borrowed huge, huge sums of market to finance expansionary policies during that housing crisis. The government was borrowing massive sums of money to help make sure our economy did not enter another Great Depression.

Even though they did borrow huge sums of money, actually, rates fell for a couple of years. And that was because the Fed also took action and enacted major expansionary monetary policy. So had they not done that, with the government entering the market for loanable funds, rates would have gone up. But because the Fed took action, rates did not rise.

So in this tutorial, we looked at how the government has to finance expansionary fiscal policy by issuing debt, generally. The government is going to pay interest to borrow money and either pays the interest with tax revenue or by rolling it over. And then these deficits, if they do roll over the debt taken on in order to expand the economy can raise interest rates as the government enters the market for loans.

Thanks so much for listening. Have a great day.

Terms to Know

Shortages that result from spending in excess of revenue.

Economic Growth

Measure of the change in real GDP over periods of time; percent change in value of the sum of goods and services produced in a country’s natural borders over a specified time interval.

Fiscal Policy

Typically policy set by a central government authority, whereby spending by the government is adjusted to stabilize economic activity.


The cost of money; nominal interest is the prevailing rate; real interest reflects the prevailing rate adjusted for inflation (real = nominal rate minus the inflation rate); return on investment where return varies based on the risk profile of the investment, time horizon, opportunity cost of a comparable risk-free investment, and inflation expectations.