How interest rates are set

• In 2009, one of the biggest concerns of many economists and commentators was the potential for higher inflation in the future, due to excessively low interest rates at the time. The concern stemmed from a relationship between interest rates and what is called "monetary policy." Monetary policy is set by the Federal Reserve Bank, which conducts "federal open market operations" through the buying or selling of treasury and other federal agency securities. The FED also can change the rate at which it lends money to financial institutions, as well as set the amount of required reserve-to-loan ratio that banks are permitted to have. The goal of the FED in using all of these tools, is to force the market to adopt interest rates that reflect the goals it sets for the economy.
  
  

How interest rates affect the economy

• The reason interest rates affect the economy is due to the availability and cost of money. When interest rates are low, it literally costs less to borrow money, because less will be spent in the long run paying it back. This is why people seek to have high credit scores in the United States, as this tends to give them a lower interest rate on loans. Lower interest rates stimulate borrowing by consumers, businesses and even financial institutions. Also, because of lower interest rates, there is little incentive to save money, and more incentive to spend it. Spending on goods and services stimulates the economy, prompting growth.
  
  

Lower interest rates equals higher growth

• While it might seem the best policy is simply to keep interest rates low indefinitely, the reality is that interest rates that are too low for too long can actually hurt the economy in the long run. There is an inverse relationship between interest rates and economic growth, so the lower the rate, the faster the growth.
  
  

The spectre of inflation

• Keep in mind, though, that such growth is, in many ways, tied not to efficiency or productivity gains, but rather to the amount of credit available. If there is too much borrowing, for example, inflation can rise significantly as the purchasing power of a currency falls due to excessive amounts of money in the system. Inflation can prevent consumers and businesses from continuing to buy goods and services and it can lead to banks raising interest rates or cutting off lending all together.
  
  

Why the FED exists

• The mandate of the Federal Reserve, therefore, is to set interest rates in such a way as to maximize growth and minimize inflation. If the FED makes a mistake and keeps interest rates too low, for example, the economy can expand too quickly, leading to exactly the kind of boom-bust period the U.S. experienced in 2008-2009 with the real estate market.