Interest Rate Effect

Interest Rate Effect Definition

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

  • Suppose an economy is overheating and the inflation is on a constant rise from say 2% to 7%, then the interest rate in the economy will be raised and this will try to bring down the inflation in the economy.
  • Similarly, if the inflation is falling in the economy from 5% to 2%, and the government feels there is a significant need for a boost to grow the economy, they may as well reduce the interest rates so that the business can borrow at a reduced rate and thus grow. This provides a stimulus for economic expansion.
Interest Rate Effect

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Advantages of Interest Rate Effect

Given below are examples of how interest rate effect on Inflation tends to benefit –

  • Stabilizing Tool – The government can very well use interest rates to stabilize the economy. This interest rate effect is then reflected in the macroeconomic environment. Suppose the economy is overheating, the interest rates are raised and when the economy is slowing down the interest rates are then reduced. This tends to then act as a stabilizing tool for the economy. Because of the interest rate effect, the economy may either expand or contract in response to certain changes brought about by it
  • Tool for Monetarists – Interest rate tends to be a favorite tool for the monetarists and interest rate effect is how they tend to move the economy towards the desired direction as taken by the central bank of any country. Monetarists do tend to believe that if the economy is expanding rapidly, the interest rates can serve as a tool to remove money from circulation by having to raise interest rates. Similarly, if the economy is contracting, the monetarists by making use of the central bank can very well tend to cut interest rates, thereby making it less expensive to have to borrow
  • Helps in Interest Rate Targeting – Inflation to a small extent is necessary for an economy to grow. By targeting the necessary amount of inflation required to be prevalent in an economy, the interest rate effect helps to achieve this by taking the necessary moves by changing the interest rates.
  • Boost for Exports – Interest rate effect through a reduction in interest rates goes on to devalue the local currencyDevalue The Local CurrencyCurrency devaluation is deliberately done in order to adjust the established exchange rates by the government and it is mostly done in the cases of fixed currencies. This mechanism is used by economies with a semi-fixed or fixed exchange rate, and it should not be confused with depreciation.read more and thereby giving a significant boost to exports of the country. The goods of the home country will now tend to be significantly cheaper and are thus less expensive for foreigners to buy. Such an impact through these effect does give an enormous boost to exports and helps exporters of the country

Disadvantages of Interest Rate Effect

However, there are certain disadvantages of the interest rate effect on Inflation –

  • Time lag – Even if the interest rate changes have been taken, it does require a significant amount of time for the interest rate effect to be visible in the economy. The effect of changes may take months or even sometimes years to even reflect and even materialize.
  • Affect the Whole Economy: Including the Untargeted Sector – Interest rate effect is a macro-economic tool and goes on to impact the whole of the economy and does not consider that some parts or sectors of the economy do not warrant or require such stimulus. It is also well known that at times the monetary policy tool being interest rate cannot be targeted to solve problems of a single sector or say even boost a specific industry or region.
  • Technical Limitations – The rate in the economy can only be lowered to a low of zero, beyond which the interest rate effect may not be able to play its desired role. If the interest rates are kept low for a relatively long period of time, it may often lead to a liquidity trap for the country.
  • Reduction in Asset Prices – An increase in interest rate would tend to reduce the valuation of financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more like stocks, bonds. The interest costs increase which eats out into the income of the business. This causes the earnings to decline and the repercussions are now felt in the stock prices which then go on to decline as well.
  • The Possible Risk of Hyperinflation – When interest rates in the economy are at a really low level, there are chances that over-borrowing at artificially cheap rates may go on to cause a speculative bubble in the economy where prices may climb artificial high levels. When more money is pumped into the economy it may certainly cause some out of control inflation. When there is more money available in circulation, it often happens that the value of each unit of money may at times decrease due to the high level of demand. This is how interest rate effect will tend to have its repercussions in the economy, often at times leading to hyperinflation brought about by the low-interest-rate environment.

Limitations of Interest Rate Effect

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

Conclusion

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

However there happens to be a certain time lag in noticing the desired results, the asset prices may fall, the economy may slip into hyperinflationHyperinflationHyperinflation is 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. It forces people to lower their holdings in that particular currency to participate in stable foreign currencies.read more and there are other possible risks too. However if 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 as well, it will certainly go on to produce the desired result.

This has been a guide to Interest Rate Effect and its definition. Here we discuss an example of interest rate effect on inflation along with advantages, disadvantages, and limitations. You can learn more about from the following articles –

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