Milton Friedman died last Thursday 16th November 2007. He was awarded Nobel Prize of Economics 1976 and was one of the most important economists of the XX century. I just want to talk here about one single thing of his long list of innovative theories, the management of the interest rate by central banks.
The Economy has cycles. Economists love to use graphics, and line graphs with peaks and troughs are their favourites. Those graphics mean that the economy has good times, when the curve goes up, and bad times, which are the crisis. The task of the economics authorities is trying to make the cycle as flat as possible, that is, to cool down the good times and try to make the bad times less severe.
One of the ways is with taxes and public investment. The trick is that when the Economy is in recession, an injection of money in the form of infrastructures or subsidies keeps the Economy going. This was the theory that worked to help recover from the 1929 crisis, the post-war recovery in Europe and Japan, and was developed by John Maynard Keynes.
The other way is playing with the amount of money available in the Economy. This was one of Milton Friedman’s contributions to the theory of Economics, the Monetarism, and it is normally managed by the central banks.
One of the tools used by Monetarism is the Interest Rate. When the Economy is growing, the movement of money increases, and Inflation becomes a real problem, because people having money in their hands tend to compete for the same goods, and those increase the price, which is the explanation of Inflation. Increasing the Interest Rate makes credits more expensive, and saving more beneficial, so the total amount of money in the economy decreases and so does the risk of Inflation.
On the other side, in periods of crisis, when people has no money or tend to save because bad times are coming, a reduction of the Interest Rate makes borrowing money cheaper and so companies can make investments, people can buy goods and the Economy starts working again.
Obviously this is an oversimplified explanation, but it works, and Milton Friedman was the first to come with the idea.