Interest and monetary expansion
As we described in the last article, a good part of inflation is a product of monetary expansion, that is, more money circulating. This excess of money in circulation causes the "price" of the currency to go down. And, for example, a bicycle seller demands more money for the same bicycle than before. That is in nominal terms, the bicycle "costs" more money. And not that the bicycle is "worth" more. If the phenomenon were reversed, that money appreciated, the bicycle would "cost" less. But at the same time, the bicycle is not necessarily "worth" less. It is important to remember this paradox in order to understand the fluctuation of prices, including that of money.
Money itself, apart from being a medium of exchange, is a "commodity". Thus the increase in the money supply puts more money on the street and its price, the interest rate, depending on the stability of the economy, will be lower or higher. In a low inflation economy, deliberate expansion of the money supply tends to lower interest rates. Money is abundant and therefore cheap. Business expands, creditors demand more money, and so on. But every paradise has its snake, as we shall see below.
When interest rates are not the product of supply and demand but of man's hand, the economy generates other risks. An artificially low interest rate creates the illusion of cheap money and induces investors to invest in assets whose attractiveness depends on that artificial rate. Thus, in the economy there is a displacement to "bad investment" in projects that, under normal conditions, would not have market profitability. When rates, logically, begin to move upward to reflect the real value of those assets, debtors and investors sink under the burden of interest they cannot afford to pay.
There are numerous painful episodes of the consequences of artificially low rates. The most recent was the market crisis of 2008, where millions of mortgages and loans were made at so-called "sub prime" rates. The supply was so attractive and the rates so artificially low that homebuyers, who under normal conditions would not have been able to afford residences, flocked to buy. Many bought not one, but several. When rates began to rise, buyers could no longer afford to pay, banks could not collect, and a global crisis of major proportions was unleashed.
Mortgage lenders were not the only victims of the rate mirage. Many companies leveraged with artificial rates also suffered. Banks and brokerage houses took huge losses. This is where the legendary investment bank Lehman Brothers went bankrupt. Governments had to deploy rescue packages to stop the crisis.
