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Interest Rate Effect

Updated on January 29, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Interest Rate Effect?

The interest rate effect refers to any changes that the macroeconomic environment undergoes because of direct repercussions caused by certain changes in the country’s interest rate.

Interest Rate Effect

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The Central Bank uses the interest rate effect to bring about the changes in the economy to have it moved in the desired direction. Therefore, it does serve as an important tool to bring the economy towards its stable state by providing the desired stimulus through such actions. As a result, the exports in the country receive a boost.

Key Takeaways

  • The interest rate effect refers to any changes that the macroeconomic environment experiences due to the direct consequences of some changes in the country’s interest rate.
  • The advantages of the interest rate effect are stabilizing tool, a tool for monetarists, it helps in interest rate targeting, and it boosts exports.
  • The disadvantages of the interest rate on inflation are its time lag. In addition, it affects the whole economy, including the untargeted sector. 
  • Suppose the Central Bank plans a robust idea to get the interest rate to achieve the expected results considering the negative points. Then, it will assuredly provide the result.

Interest Rate Effect Explained

The term interest rate effect refers to changes in the economic conditions and activity levels of a nation due to changes in interest rates. The policymakers and the government of the country use this concept to influence the economy by controlling interest rates.

Due to changes in rates, there may be increase or decrease in demand, spending or borrowing patterns and overall economic condition of the nation. The central bank alters the rates to maintain a sustainable growth within the country, and the consumers, borrowers, and banks react to it, which is terms as the interest rate effect on inflation, demand and economic growth.

Suppose an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more is overheating and constantly rising from 2% to 7%. Then, naturally, it will raise the interest rate in the economy, and this will try to bring down inflation in the economy. Here, the economy faces a contraction effect because the rising rates increase the borrowing cost. Borrowers will now have to pay higher rates to take loans, thus, leading to less lending, less spending, investment and consumption. The economy contracts, curtailing growth and inflation.

Similarly, suppose the inflation is falling in the economy from 5% to 2%, and the government feels a significant need to boost the economy. In that case, they may reduce the interest rates to borrow at a reduced rate and thus grow. Again, interest rate effect on business provides a stimulus for economic expansion.

This situation is just the opposite of the previous one, because here the economy expanding due to higher borrowing, consumption and investment since people can afford to do so due to lower interest rates.

So, the above situations prove that the concept may have both positive and negative effect. However, it depends on what the government plans to do or aims for and what is needed for the economy.

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Examples

Let us understand the concept with the help of some suitable examples.

Example#1

We assume that an economy is facing an inflationary pressure of 12%. Due to this, the prices of goods and services are rising at an exorbitant level leading to increase in demand for higher wages and salaries by workers. The manufacturers need to spend more money of salary payment and at the same time the cost of production increases due rise in prices. The government will take steps in such a situation to control it and bring down the inflation at a level of 4-5% by increasing the interest rates. Thus, interest rate effect on inflation is such that, if the rates increase, the banks will start lending money at a higher rate, which will become costly for the borrower. The borrowers may be individuals as well as corporates.

Thus, the above will lead to less borrowing, interest rate effect on business and economy will be such that there will such that there will be lesser money will be available in the hands of consumers. There will be very controlled spending and investment, resulting in lower demand. This will not only bring down the prices and reduce inflationary pressures, but also less spending and investment will contract the economic conditions, resulting in less growth and expansion. If the government is able to strategically handle the situation, the inflation may come down to 4-5%, as per their target lvels.

However, the opposite will happen in case the rates are reduced, but such a step is taken if the economy is facing a deflationary situation.

Example#2

Recently, the Federal Reserve has unanimously decided that it will keep the interest rates at the same level, which is between 5.25% to 5.5%. This level has been the same since the last quarter. This decision is based on the fact that the economy is now steadly growing without any sign of increase in inflationary pressure.

The Fed has already hiked the rates 11 times, which include 4 times in 2023 itself. They believe that the US economy is at a moderate level after a huge mismatch in the demand and supply of the labor market last year.

Advantages

Given below are examples of how interest rates affect inflation tends to benefit: –

Disadvantages

There are certain disadvantages of the interest rate effect macroeconomics on inflation: –

  • It can reduce the interest rate to a low of zero, beyond which the interest rate effect may not come into play.

However, there happens to be a certain time lag in noticing the desired results. The asset prices may fall, and the economy may slip into hyperinflationHyperinflationHyperinflation is merely an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services, and it causes people to lower their holdings in that particular currency as they opt to participate in foreign currencies that are relatively more stable.read more, and other possible risks. However, suppose the Central Bank tends to plan out a robust full-fledged plan to have the interest rate achieve the desired results after considering the negative points. In that case, it will certainly produce the desired result.

Frequently Asked Questions (FAQs)

How does the interest rate effect inflation?

Inflation decreases when the interest rate is high and the money supply is less. Therefore, supply also decreases. Moreover, if the interest rate is low, inflation increases. As a result, the supply of money and demand also increase.

What is the interest rate effect on currency?

The country’s currency value typically increases when the interest rates are high. That is why the high-interest rates are bound to appeal the foreign investment. In addition, the country’s currency value and demand will also increase.

How much does interest rate effect the housing market?

If there is a 1% rise in the home loan, the interest rate diminishes the purchase affordability by 7.4%.

What does the Fed interest rate effect?

If the Fed increases the interest rates, borrowing the money is expensive. As a result, the industry will have higher rates depending on financing, credit cards, auto loans, etc. It can be distressing for those consumers who rely more on loans or credit cards.

This article is a guide to what is Interest Rate Effect. We explain the concept with the help of some examples, advantages and disadvantages. You can learn more about it from the following articles: –

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