Interest rates and capital investment across four economic scenarios

Economic Scenarios

Higher interest rates, more capital invested

During the 1980s, when President Reagan was attempting to stimulate the economy, he radically lowered taxes. The U.S. was in the grips of 'stagflation,' or high unemployment and high inflation, a combination which historically is not supposed to occur together. The lower corporate taxes and lower taxes for wealthy individuals eventually encouraged more investment in business. "The Fed was resolved to stop inflation…[and] kept raising rates in 1980 and '81, eventually bringing both the economy and inflation to a standstill" (Solomon 2009). By the mid-80s, interest rates were still high, but investment capital in the economy had increased.

Lower interest rates, less capital invested

Low interest rates and low rates of capital invested in the economy are usually characteristic of a recession. This occurred very recently, during the Great Recession of 2008, when the Fed slashed interest rates to historically low levels to stimulate growth. "The Federal Reserve surprised Wall Street…by cutting its fed funds short-term interest rate target by three-quarters of a percentage point…The move had the effect of reducing rates on mortgages and home equity loans, and reassured investors that the Fed will do what it can to spur economic activity as long as the threat of recession looms" (Barr 2008). However, despite this encouragement to banks to lend money, there has been a widespread reluctance amongst many businesses to expand and hire more workers.

Higher interest rates, less capital invested

High interest rates with relatively low levels of capital were characteristic of the early 1980s; right after the Fed dramatically increased interest rates to curtail inflation. The U.S. went through a severe recession before the economy began to recover (Solomon 2008).

Which of these four scenarios are most important today? Which scenario is most conducive toward economic growth? Which scenario is the most normal historically?

Today, interest rates are low, but there is relatively little capital being invested because of concern about the economy. The scenario most conducive to economic growth are low interest rates and high levels of capital investment, which means that it is cheap to borrow and there are many incentives and opportunities to invest in expanding enterprises. In general, in America it has been more common for interest rates to be relatively high to combat inflation (given that prices are almost always going up) combined with relatively high rates of capital investment.