Analogy : Putting out fire by pouring gasoline?

So Bank Negara has decided to reduce the interest rate for savings to a benchmark of 2% and interest rates for borrowings to 4.5% to cure the recession in our country. (Mind you, decisions of the Central Bank often are greatly influenced by our Finance Minister)

Ah, yes. Low interest rates. Like the resounding chorus of Hallelujah to ears of the investors, households and many who speculate.

Low interest rates would cause savings to decrease. Thus consumption increases, leading to rise in aggregate demand. When aggregate demand (demand for goods and services) increases, there would be more job opportunities. Hence, income increases. Therefore, curbing recession in Malaysia.
Also, low interest rates would allow for increase in investments, as entrepreneurs can borrow at a low cost to invest. Thus stimulating the economy and bringing growth to our country in technology and productivity. Aggregate demand increases, unemployment decreases and income increases, curing the looming recession.


So then you ask, what flaw could there possibly be in reducing the interest rate?
Do allow me to enlighten you with what I have learn.

When interest rates are low, it might not encourage investors to loan from banks because they might speculate that they would not meet their break even point as profits would not be as high in times of recession.

Also, when the interest rates are reduced, savings might not reduce as household save in banks abroad which offers high interest rates. Thus, money for transactionary purposes would not increase as it is kept in the banks. So, the whole theory of consumption increasing, pushing up aggregate demand and increasing income will fail.

A good example of the failure of reduction of interest rates, hoping to cure recession would be the Japan government's intervention of reducing interest rates to 0%. You are sorely mistaken if you think that would have stimulated the economy. No, investors did not borrow to invest. Households still kept their money in banks even when there would be zero returns. The economy continues to stagnate even when the cost of borrowing is zero. Why then, you might ask. Well, simply because the people of Japan figured there was something seriously wrong that the interest rates dropped to 0%, thus start feeding their savings account, afraid what they would be facing in the future, that interest rates dropped so severely.


The fall in interest rate might be one of the ways to curb recession. But it is not the best way. It might just be like pouring gasoline, thinking it would put out the fire.

So, lets wait and see if the pros outweighs the cons. Or vice versa. Hopefully it doesn't.


(Source : Words of wisdom by an Economics lecturer.)