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Is the interest rate tool effective?

As we mentioned in one of our other articles the interest rate tool is one which has been used by many governments around the world to control local economies. In times gone by there is no doubt that increasing and decreasing interest rates has impacted upon the degree of economic activity and been known to calm down buoyant economies and increase activity in lacklustre economies. However, while it is very effective in many scenarios the interest rate tool has been fairly ineffective during the credit crunch – but why?

The problem in the ongoing economic situation is the fact that it is not the cost of borrowing which has been an issue it is the fact that there was very little liquidity in the money markets. As a consequence, the cost of borrowing could have been 20% or 1% and it would have made little difference because ultimately there was no liquidity. The collapse in worldwide banking assets around the world had a domino effect on investment markets and former "safe havens" came under attack and many people lost significant amounts of money.

In a traditional economic cycle the interest rate tool can and has been very effective but in one which is impacted by the degree of the liquidity in the money markets it has in reality been very ineffective.

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