Principles of Economics/Interest Rates

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The rate of interest is a return on savings set by the national bank, meaning that if an individual saves a sum of money in a bank, they will receive a rate of interest similar to that set by the central bank. Because of this, a change in the rate of interest will result several macroeconomic effects. A rise in interest rates will:

  • reduce consumption and investment, and consequently AD. This is due to the fact that individuals and firms will be more inclined to save wages and profits than invest or spend them, as the return on saving per year is greater
  • raise the cost of borrowing from banks, as the rate of interest on repayments is greater. This could further reduce spending and investment
  • encourage foreign investment in domestic institutions and firms to increase, as a high rate of return on savings is attractive. High demand for the currency will raise its value (like any other product). This would lead to an increase in the price of exports and a fall in the price of imports, resulting in an increase in imports and fall in exports as they are less competitive globally. This would lead to a fall in AD ( X - M )

The major purpose of a rise in interest rates is to 'cool down' an economy that is overheating ie. to reduce inflationary pressure due to high aggregate demand and no complementary increase in long run aggregate supply.

The exact opposite applies to a fall in interest rates. A cut in interest rates is often used to aid economic recovery and boost consumer demand, make exports more competitive, and encourage capital investment by firms.