What Is Cheap Money?

Terry Masters

Cheap money is typically the result of a country's monetary policy. Poor economic conditions sometimes force a country to try to manipulate markets and consumer spending by changing the interest rate set by a central bank, such as the Federal Reserve Bank in the U.S. When a central reserve bank lowers the interest rate on government debt, it makes credit easier to obtain. Thus, the cost of borrowing money becomes cheaper, causing analysts to refer to the phenomenon as creating cheap money.

Cheap money exists when a central bank, like the U.S. Federal Reserve Bank, lowers interest rates.
Cheap money exists when a central bank, like the U.S. Federal Reserve Bank, lowers interest rates.

The cost to borrow money from a bank or private lender is the interest rate they charge. High interest rates mean that the money is very expensive to borrow. For example, the monthly payment on a loan with a high interest rate will be very high, but the loan will take longer to pay off. This is because most of the loan payment goes to pay the high interest, while the principal of the loan remains unpaid. Buyers tends to shy away from making major purchases that must be financed when interest rates are very high.

Conversely, low interest rates mean there is a lower cost to borrowing money. Consumers tend to make significant purchases when interest rates are low. Knowledge of this fact can enable an interest-setting agency, such as a central reserve bank, to try to manipulate consumer behavior by enticing the public with lower interest rates. A monetary policy that supports cheap money is designed to stimulate economic growth. Often, this is a strategy used to ward off a recession.

Central reserve banks do not control the interest set by lenders in a direct sense. A country's central reserve bank sets the interest rate on government debt instruments, such as treasury bonds. Private lenders often peg their interest rates to a certain number of percentage points above the interest rate on government debt. So if the interest rate on government debt goes down, it brings down all of the rates that use it as a standard.

Some economists believe cheap money stimulates growth. It certainly does encourage spending and boost stock prices, but whether those results can prevent a recession is debatable. Cheap money can cause inflation, however. To ward off inflation caused by the over-availability of cheap money, the central reserve bank will eventually raise the interest rate again. This action creates tight money, or money that is expensive to borrow and inaccessible, or tight, as a result.

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