Cycles, Trends and Financial Crisis: Understanding the Impacts of Monetary Policies

Abstract

Low interest rate environment encourages borrowing. During inevitable downturns in business cycles, heavy borrowing makes it more vulnerable to financial crisis. Low interest rate environments also favor high fixed cost investments, which have low variable costs and hence, have more significant scale economy than low fixed cost investments. In a large and growing economy, high fixed cost investments earn higher rates of returns than low fixed cost investments. During last several centuries, fueled by the abundant cheap nonrenewable resources, the global economy has been expanding more or less uninterrupted. In such a growth economy, low interest rate policy, which favors high fixed cost investment, has been mostly beneficial to overall economic activities, although it also induces financial crisis from time to time. However, many signs indicate that the upward trend of economic output will end soon. In the new environment, higher and stable interest rates will narrow the gap between cost of borrowing and expected rate of inflation, which will reduce the incentive for speculation. A high interest rate environment will also enhance the competitiveness of small firms as low fixed cost entities. Small firms are more labor intensive and less resource intensive, which is especially helpful in a world with increasing resource scarcity and high unemployment rates.