That low interest rates and printing money leads to higher economic growth, job creation and a reduced unemployment rate is both textbook economics and conventional wisdom. Whether it is true or not is another story, but here’s the rationale. There’s at least four related mechanisms at work.
First, low interest rates encourage businesses to borrow. For businesses, projects that might have been prohibitively expensive to fund at higher interest rates and a higher cost of capital can get funded. Business expansion will naturally lead to a need for more workers. Similarly, entrepreneurs will have the ability to raise money to start companies that would not have been founded in a higher interest rate environment. More new businesses will again lead to higher employment.
Second, consumers, like businesses, will spend and borrow more. Low interest rates discourage savings, since a saver earns less interest income. Less savings means more consumption. Plus, consumers are more apt to borrow money to fund consumption of homes, cars and other items. Higher consumption means greater demand for goods and services, which encourages businesses to expand and of course, hire.
Third, low interest rates encourages banks to lend by increasing the amount of lendable reserves on the balance sheets of banks. The Fed does not technically set the key interest rate that banks lend to each other (the Federal Funds Rate), but targets a rate by buying and selling securities (e.g. government debt) from banks. Buying securities from banks adds newly created money to bank reserves that can be lent out to businesses and consumers. Since banks earn little or no income on these excess reserves, they have an incentive to lend them and earn more interest income. More lending for consumption and especially for businesses investment leads to job creation.
Fourth, low interest rates raise asset prices, which encourages consumption through what is known as the “wealth effect.” Other things equal, the lower a company’s cost of capital, the higher its valuation. And this is true for all financial assets, including stocks, bonds and real estate. In fact, raising asset prices is a direct objective of easy monetary policy. The idea being that individuals with fatter brokerage accounts will go out and spend more money, thus encouraging business investment and employment, just like we mentioned above. Whether this “wealth effect” actually happens is not without controversy, but it has been supported by statements from Fed policy makers, including former chairman Ben Bernanke.