What is Interest Rate Effect?
Written by True Tamplin, BSc, CEPF®
Updated on June 21, 2021
Interest Rate Effect Definition
Interest rates have an inverse relationship with aggregate demand. When rates are high, demand is low and vice versa.
These changes in demand affect consumer expenditures and the state of the overall economy.
Interest Rate Effect Explanation
A country’s central bank is responsible for setting the interest rate at which it lends money to banks.
The rate setting ripples through an economy through banks and other financial institutions that lend to businesses and consumers.
Together, these institutions use interest rates to calibrate the economy’s velocity and stimulate or tamp down on demand, as the case may be:
- High interest rates have a contractionary effect on an economy because they increase the cost of borrowing. With less money circulating in the system, people are discouraged from spending and consumer demand for goods and services falls.
- Low interest rates have the opposite effect of high interest rates. They speed up an economy by making it easy to borrow from banks. There is more money in the system and people are encouraged to spend and consumer demand for goods and services rises.
Interest Rate Effect Example
Suppose a home loan borrower has an adjustable rate mortgage that charges a 10% annual interest rate on a loan of $200,000.
The borrower will have to pay $20,000 in the first year.
The Federal Reserve slashes rates by one percentage point the next year.
The mortgage issuing agency decides to pass on the entire savings to the borrower and adjusts rates to 9% .
This means that the borrower will have to pay $18,000 in interest payments next year, leaving them with $2,000 more cash to spend on other goods or services.
Positive vs. Negative Interest Rates
While we know the effect of high and low positive interest rates on an economy, the consequences of having negative interest rates are still being documented.
Japan and Switzerland are two prominent countries which have introduced negative interest rates in recent times.
Negative interest rates have a positive effect on exporters because the local currency is devalued and becomes cheaper.
But it is still an open question as to whether negative interest rates can induce economic growth by encouraging consumers to spend money.