Why could low interest rates undermine an economy?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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There are at least two ways in which excessively low interest rates could undermine an economy.

First, low interest rates could lead to inflation.  If interest rates are kept too low, it will be too easy to borrow money.  This could overstimulate the economy, leading aggregate demand to rise faster than aggregate supply.  This will likely lead to inflation, which is bad for the economy.

Second, low interest rates can lead to bubbles such as the one that hurt the US economy so badly in 2008.  When interest rates are low, people can easily borrow money to speculate in things such as housing.  Businesses can easily borrow money to invest in ventures that are riskier than is prudent.  If too much of this sort of borrowing happens, the economy can be hurt badly if the bubble pops.  Banks, for example, can lose a great deal of money if the risky loans mentioned above cannot be repaid.  This is the sort of thing that caused the financial crisis in the US and elsewhere beginning in 2008.

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