Central Bank Interest Rate Policy as a Pro-Crisis Instrument of Macroeconomic Regulation

Abstract

Why does interest rate policy not work in the economy as economic theory suggests? To understand why, you need to look at the economy from a higher level of abstraction. With this approach, only two states of the economy can be distinguished. The first is a “normal” state; the second is crisis and recession. The “normal” state is the period after the recession and before the next crisis. During this period, the basic laws of the market economy work. During a crisis, the relationship between the level of interest rates and borrowing by households and businesses is broken. This explains the ineffectiveness of the policy of lowering interest rates. Different states of the economy have their own laws, and you cannot extrapolate tools that are successful under “normal” market conditions linearly to the crisis state of the economy. Why does the interest rate policy during the period of the “normal” state of the economy not adjust its development in order to prevent the onset of the crisis? Firstly, the conditions for the emergence of crisis phenomena are created by the interest rate policy at the very beginning of the business cycle, when central banks set and maintain low interest rates for a relatively long period. Secondly, by the end of the business cycle, the credit burden in economy reaches its maximum, so there is no further possibility of expanding effective demand by decreasing interest rates. Thirdly, interest rate policy is an instrument for rough adjustment of the economy, indiscriminately affecting all participants in economic relations. In an attempt to stimulate the economy, the central bank creates the conditions for increasing its imbalance. Fourth, at the end of the business cycle, the interest rate policy does not actually support the real economy, but only the stock market. Fifth, the Fed’s policy has formed a pro-crisis conditioned reflex among market participants. Thus, central banks should leave the determination of the level of interest rates to the free market.