Interest rate (the price of borrowing) is directly linked to investment (by firms in the forms of capital or inventory, and by household in the form of new housing). Thus, interest rates affect the "quantity" of investment (which is a component of GDP since GDP=C+I+G+NX). In such, we are concerned with the real interest rate, not nominal interest rate. Real interest rate is simply the nominal interest rate (that rate that is found on the loan contract) minus inflation rate. Remember, and as we discussed during the first 3 weeks, market demand and market supply are affected by prices. Since interest rate is the price of borrowing, we expect demand for borrowing (the quantity) to increase when real interest rates are low and decrease when real interest rates are high. At the same time, suppliers have more incentive to supply the market with more loanable funds if the prices (interest rate) are high and supply the market with fewer loans if the interest rate is too low. For the economy to grow, suppliers (firms and businesses) need to have access to funds (loans) to purchase capital for their production function. When firms borrow funds to purchase capital, they will produce more, which means they can employ more people, which causes the overall output in the economy (GDP) to increase.
During period of decline in economic activities (recessions) where unemployment rates are above the normal rates (more layoffs), would you consider a government's decision to reduce interest rates a viable solution to stimulate the economy to employ more factors of production (capital and people)? Is it possible (or beneficial) to keep the interest rates low for a long period of time?
Justify your answer for both the short and the long-run, keeping in mind the effect of inflation rates on such decision.