The interest rates play an important role because it motivates people to borrow if it is low enough.  When the interest rates were dropped to zero, it basically made it free to borrow money.  Why...

The interest rates play an important role because it motivates people to borrow if it is low enough.  When the interest rates were dropped to zero, it basically made it free to borrow money.  Why do you think it didn't work?  Was it hesitation by consumers to make big purchases (and have to pay back a loan) during uncertain times?  Was it hesitation by banks who didn't want to lend money if they weren't going to earn any interest?  Or was it that banks were being more cautious because of the collapse of the financial market?  All of the above?

Asked on by sj83

1 Answer | Add Yours

pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

This question touches on an important issue.  The increase in the money supply in response to the “Great Recession” has not had the impact on lending and borrowing that it “should” have.  This has been one reason why the economy has not rebounded very quickly, even given the low interest rates and the quantitative easing that the Fed has undertaken.

So why did this happen?  In a way, we cannot answer that because we cannot know for certain why banks did not lend and people did not borrow.  However, all of the factors that you mention in this question have been proposed as reasons why the economy did not improve.  The most important was probably the last factor.

When the Great Recession started, people and firms did become reluctant to borrow.  Even at low interest, most people do not want to take on debt if they fear they will lose their jobs.  Firms do not want to borrow if they fear that they cannot sell their products.  With the interest rates so low, banks do have less incentive to lend because they will not make as much money for doing so.

However, the most important factor was probably the banks’ unwillingness to lend.  The financial crisis was caused in part by banks lending too much money to people who could not repay the loans.  Naturally, this led to a reaction in which banks did not want to loan, even to good credit risks, for fear of being wrong again and losing money again. 

So, all of the factors you mention probably matter, but the last factor is the most important of the causes.

We’ve answered 318,982 questions. We can answer yours, too.

Ask a question