How do Interest Rates Influence the Economy?

How do Interest Rates Influence the Economy?


Interest rates have an important part to play in the overall activity of economies, generally, as well as the progress of the nation in question; When a central bank of a country changes the interest rates, it majorly influences the investment, asset and any other commodity market related to finance.


Why central banks changes the interest rates when the Economy is Growing Too Quickly?

Organizations are profiting; unemployment rates are low; consumers are spending more money; In such scenarios, central banks tend to increase their short-term interest rates, in a bid to curb the economy from growing too rapidly, and risk-taking with inflation. Surges in price are what define inflation, which occurs due to an imbalance between the availability of cash and the merchandise, as well as services which are purchasable.


When the Economy is Slowing Down?

In this scenario, organizations are suffering losses; the unemployment rate is inclining, consumers are refraining from the spending of money, and due to such factors, creating a bearish market. Central banks tend to decrease short-term interest rates, in an attempt to attract communities to borrow money, and to make it easier/more affordable to borrow. Because of lower interest rates, consumers and businesses can access to products and services in more affordable manners.


Eventually, economic growth becomes fueled by this, and it may save the economy from recession. When consumers interact with cash retention, by saving money as opposed to spending it, a recession is defined. When interest rates are lower, it means that there is sufficient liquidity in banks, which makes lending easier, by lowering the cost of borrowing.


It is essential to note that the Central Bank of a nation is not responsible (solely) for the fluctuation interest rates; there are specific events, such as geopolitical and natural events, disasters (natural or not), economic crises, and more. For example, the Bank of England had cut the interest rates in 2016 to a record low of 0.25%, due to the weak economic activity, which occurred due to Brexit.


Impact of Higher Interest Rates

  • The Cost of Borrowing Increases– the higher the interest rate, the more costly that loans become; this translates to people refraining from borrowing, and those who have opted for loans will need to sacrifice a huge portion of their income in order to pay-back the high-interest payments.
  • Decrease in Overall Expenditure– Due to shortage of disposable income, people will not spend so much on goods and services. If this happens, liquidity shortage occurs in the market, hereby leading to a bearish economy.
  • Lowered Confidence– Surges in interest rates negatively affect both consumers, and businesses. Due to a liquidity crisis, companies would not be able to roll out new investments and expand their products/services.
  • Increased Foreign Exchange– Higher rates translate to an increase in foreign investments in order to capitalize on the higher interest rates, therefore a rise in the local currency occurs with regards to the investments which need converting to.


Impact of Lower Interest Rates

  • The Cost of Borrowing Increases– declines in interest rates makes loans more accessible/affordable; this would encourage people to apply for loans at smaller interest rates, which would mean an incline in disposable income.
  • Increase in Asset Prices– when the rates of interest decline, it is easier to buy assets, such as vehicles or homes, through financing options. This initiates a rise in prices for the assets, and in turn, increases wealth.
  • Increase in Liquidity– an increase in disposable income due to the decline of interest rates; this may trigger consumers to spend more money on goods and services. In turn, this will lead to higher liquidity and eventually, a better economy.
  • Decreased Foreign Exchange– Declining interest rates are less attractive to foreign investors, which means that a translation of lower currency value with regards to the nation in question.

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