Interest Rates

[Scotty]

Hi there,

I need something clarified for me as I believe contradicts itself on several occasions....

When interest rates increase, should consumer spending increase or decrease, should investments increase or decrease and should borrowing increase or decrease?

What I believe is that it depends on future expectations of economic growth and future inflation but sometimes in the notes it will say one and sometimes the other.

For example in one place it says "interest rates increasing will cause consumer spending & investments to decrease"....makes sense as there is a lower opportunity cost in saving now. However I've also seen it say that "a decrease in interest rates will mean consumers will save more"...as they need to save more to earn the same interest.

I think I've seen something similar with the money supply and interest rates too.

Help please.

Scotty

 

[johnmunge]

Hi,

Here's the way I usually think about it. The interest rates referred to here are the interest rates charged by banks for borrowing money or the interest rates earned by investors when, say, they open a fixed deposit account in a bank. The latter being slightly lower. The two rates will be dependent on the central bank lending rate ie the rate at which banks borrow money from the central bank.

When the central bank increases the base lending rate, banks will have to pay more interest since the usually borrow from the central bank. They will transfer this cost to their customers by also raising their interest rates. Hence it will be more expensive to obtain financing. Individuals disposal income will reduce. Money will be scarce( as this is actually a contraction awry monetary policy). Hence Consumer spending will decrease and so will the amount of DOMESTIC investments.

A decrease in interest rates will have the opposite effect. The will be more money flowing in the economy. Obtaining finance will be cheaper. People will have more disposable income thus increasing demand for goods. However, this can lead to demand pull inflation. The availability of cash will mean that people will start investing/saving.

I hope that helps. I might be wrong though. Am also learning and am typing this at 2 in the morning.

Regards,
John

However, the higher interest rates will mean that

 

[Anna Walklate]

The standard link is that a rise in interest rates will lead to a fall in consumption and a fall in investment. This is because:

- saving is now more attractive
- borrowing is expensive.

There are of course other factors that affect both consumption and investment. For example, consumption depends on households' disposable income (which depends on national income), and also consumer confidence. Investment depends on a number of things, such as profitability, the tax regime and business confidence (which will depend on expectations of future growth).

The other impact you mention relates to consumer confidence. A decrease in interest rates will worry savers, who may then save more (and so spend less) as a result.

Yes, this can be a bit confusing! But (unfortunately!) relationships in economics (and in the real world) aren't simple. The standard way of thinking is that higher interest rates lead to lower consumption and investment, as there should be a direct link between these variables. The latter effect is more of an indirect effect, and I would probably only tend to mention it in long-answer questions.