The Impact of Interest Rates on the Economy
Interest rates, often regarded as the lifeblood of modern economies, wield significant influence over various economic activities. They act as a powerful tool for central banks to manage economic growth, inflation, and employment levels. It is a constant topic of conversation as movements or lack of have drastic affects in all aspects of economy and felt through everyday living.
Interest Rates
Interest rates are the cost of borrowing money, charged as a proportion of a loan. Loans are necessary for individuals, businesses, and other groups with the common purpose of purchasing, investing, etc. When money is borrowed, it must be paid back with an additional sum, interest, to serve as compensation to the lender. For most of us these lenders being banks.
Central Banks
Central banks are independent financial institutions that influence macroeconomic objectives, done through monetary policy, issuing currency, and helping regulate banking systems. Looking strictly at interest rates, Central banks like the US’s Fed and Australia’s RBA, influence them through cash rates. Cash rates is the interest rate banks pay to borrow funds from other banks in the money market overnight. Typically released once every month, the cash rate sets the tone for financial markets; a cooling, heating, or maintaining view of the domestic economy which has rippling effects globally.
Consumption
One of the controlling factors in the invisible hand of the free market economy, interest rates influence consumer behaviours and investing choices. Simplified, low interest rates allow borrowing to be cheaper, encouraging consumers to take spend; taking loans for a range of purposes including but not limited to buying property, cars, funding research or investing in technology/equipment. Doing so stimulates the economy.
Conversely, higher interest rates discourage borrowing and overall spending, typically done to slow down economic activity. Consumer behaviour sees more people become frugal in these periods, likely taking advantage of banks’ higher interest rates by moving money into their bank accounts.
Inflation
The big bad word feared by people of 2023. Inflation refers to the increase in general prices of goods and services over periods of time. Price increases can be influenced by numerous factors, demand rising for goods and services, costs pushing on productions, and other factors. Unfortunately, phases like “cost of living crisis” are common in times of high inflation and slower wage growth. Inflation erodes consumes savings and hurts their purchasing power, making essential goods more difficult to purchase. A dollar now is worth less than a dollar in the past, as its ability to buy the same items has diminished.
Central banks use interest rates to control inflation by adjusting borrowing costs in response to changes in inflationary pressures. When inflation exceeds the central bank’s target, it may raise interest rates to reduce spending and investment, thereby cooling down the economy and curbing inflation. Conversely, if inflation is below the target, the central bank may lower interest rates to stimulate economic activity and push inflation toward the desired level.
The Influence
Interest rates play a multifaceted role in shaping economic activity, influencing everything from borrowing and spending to saving and investment decisions. Central banks carefully monitor and adjust interest rates to achieve macroeconomic objectives such as price stability, full employment, and sustainable economic growth. Understanding the dynamics of interest rates and their impact on the economy is essential for policymakers, investors, and individuals navigating the complex world of finance and economics. When making financial decisions that require borrowing it is imperative to know the cost to be paid back.
