Interest rates and their influence on the economy

Financial Management

There are many reasons why interest rates are important in an economy. First of all, interest rates are a benchmark for the economy, often giving an overall outlook of where the economy is at a certain moment. An economy where the Central Bank has fixed low interest rates is likely an economy in recession, where growth is expected by reducing the return on saving and, thus, the encouragement of investment and spending.

At the same time, this leads to another important role for the interest rates. Interest rates influence the business cycle

The Central Bank sets the level of the interest rate, which, in turn, is used by the banks to determine their own lending rates (the commercial banks loan money from the Central Bank at an interest rate referred to as the bank rate)

. The lending rates represent the cost for a business to take a loan and make an investment. That interest rate will be used by the company in its evaluation of whether an investment is valid or not. If the cost of the loan is bigger, as a percentage, than the return on the investment, then the investment is not justifiable.

The interest rate also has an impact on the economy in that they represent a return on savings. Individuals place their money in the bank, in the form of deposits, or invest in different short or long-term financial instruments, such as governmental bonds. The return for these investments is regulated through the use of interest rates. The higher the interest rate, the higher the return. At the same time, the return will also impact the incentive that an individual would have towards either spending money he has on purchases or investing in such instruments. With a higher interest rate, the consumer is likely to prefer saving over spending, and this eventually translates into changes of several other macroeconomic indicators.

For example, if spending is encouraged, in the form of lower interest rates, then inflation is likely to grow, at least in the short-term, before the government has a chance to regulate this problem and move interest rates in a different direction. With higher inflation, the purchasing power of the individuals is affected, which might, in turn, lead to a decrease in aggregate demand over time.