Interest Rate Effect

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

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

• The interest rate effect refers to any changes that the macroeconomic environment experiences due to the direct consequences of some changes in the country's interest rate.
• The advantages of the interest rate effect are stabilizing tool, a tool for monetarists, it helps in interest rate targeting, and it boosts exports.
• The disadvantages of the interest rate on inflation are its time lag. In addition, it affects the whole economy, including the untargeted sector. 
• Suppose the Central Bank plans a robust idea to get the interest rate to achieve the expected results considering the negative points. Then, it will assuredly provide the result.

The term interest rate effect refers to changes in the economic conditions and activity levels of a nation due to changes in interest rates. The policymakers and the government of the country use this concept to influence the economy by controlling interest rates.

Due to changes in rates, there may be increase or decrease in demand, spending or borrowing patterns and overall economic condition of the nation. The central bank alters the rates to maintain a sustainable growth within the country, and the consumers, borrowers, and banks react to it, which is terms as the interest rate effect on inflation, demand and economic growth.

Suppose an economy is overheating and constantly rising from 2% to 7%. Then, naturally, it will raise the interest rate in the economy, and this will try to bring down inflation in the economy. Here, the economy faces a contraction effect because the rising rates increase the borrowing cost. Borrowers will now have to pay higher rates to take loans, thus, leading to less lending, less spending, investment and consumption. The economy contracts, curtailing growth and inflation.

Similarly, suppose the inflation is falling in the economy from 5% to 2%, and the government feels a significant need to boost the economy. In that case, they may reduce the interest rates to borrow at a reduced rate and thus grow. Again, interest rate effect on business provides a stimulus for economic expansion.

This situation is just the opposite of the previous one, because here the economy expanding due to higher borrowing, consumption and investment since people can afford to do so due to lower interest rates.

So, the above situations prove that the concept may have both positive and negative effect. However, it depends on what the government plans to do or aims for and what is needed for the economy.

Let us understand the concept with the help of some suitable examples.

Example#1

We assume that an economy is facing an inflationary pressure of 12%. Due to this, the prices of goods and services are rising at an exorbitant level leading to increase in demand for higher wages and salaries by workers. The manufacturers need to spend more money of salary payment and at the same time the cost of production increases due rise in prices. The government will take steps in such a situation to control it and bring down the inflation at a level of 4-5% by increasing the interest rates. Thus, interest rate effect on inflation is such that, if the rates increase, the banks will start lending money at a higher rate, which will become costly for the borrower. The borrowers may be individuals as well as corporates.

Thus, the above will lead to less borrowing, interest rate effect on business and economy will be such that there will such that there will be lesser money will be available in the hands of consumers. There will be very controlled spending and investment, resulting in lower demand. This will not only bring down the prices and reduce inflationary pressures, but also less spending and investment will contract the economic conditions, resulting in less growth and expansion. If the government is able to strategically handle the situation, the inflation may come down to 4-5%, as per their target lvels.

However, the opposite will happen in case the rates are reduced, but such a step is taken if the economy is facing a deflationary situation.

Example#2

Recently, the Federal Reserve has unanimously decided that it will keep the interest rates at the same level, which is between 5.25% to 5.5%. This level has been the same since the last quarter. This decision is based on the fact that the economy is now steadly growing without any sign of increase in inflationary pressure.

The Fed has already hiked the rates 11 times, which include 4 times in 2023 itself. They believe that the US economy is at a moderate level after a huge mismatch in the demand and supply of the labor market last year.

Given below are examples of how interest rates affect inflation tends to benefit: -

• Stabilizing Tool – The government can use interest rate effect on currency and borrowing to stabilize the economy. This interest rate effect is then reflected in the macroeconomic environment. For example, suppose the economy is overheating, the interest rates are raised, and the interest rates are reduced when the economy slows down. It 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 it brought.
• Tool for Monetarists – Interest rate tends to be a favorite tool for monetarists. The interest rate effect tends to move the economy towards the desired direction of any country's Central Bank. Monetarists tend to believe that if the economy is expanding rapidly, the interest rates can serve as a tool to remove money from circulation by raising interest rates. Similarly, if the economy is contracting, the monetarists, by using the Central Bank, can very well tend to cut interest rates, thereby making it less expensive to borrow.
• Helps in Interest Rate Targeting – Inflation is necessary for an economy to grow to a small extent. By targeting the required amount of inflation in an economy, the interest rate effect on currency and borrowing helps achieve this by taking the basic moves and changing the interest rates.
• Boost for Exports – The interest rate effect through a reduction in interest rates devalue the local currency significantly boosting country exports. The home country's goods will now be considerably cheaper and are thus less expensive for foreigners to buy. Such an impact through these effects does give an enormous boost to exports and helps exporters of the country.

There are certain disadvantages of the interest rate effect macroeconomics 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. As a result, the impact of changes may take months or even sometimes years to even reflect and even materialize.
• Affect the Whole Economy: Including the Untargeted Sector – The interest rate effect is a macroeconomic tool that impacts the whole economy and does not consider that some parts or sectors do not warrant or require such stimulus. It is also well known that the monetary policy tool being interest rate cannot be targeted to solve problems of a single sector or, 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, it may often lead to a liquidity trap for the country.
• Reduction in Asset Prices – An increase in interest rate would reduce the valuation of financial assets like stocks and bonds. The interest costs increase, which eats out into the business's income. That causes the earnings to decline, and the repercussions are now felt in the stock prices, which then fall.
• 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 cause out-of-control inflation. When there is more money available in circulation, the value of each unit of money may at times decrease due to the high level of demand. That is how the interest rate effect macroeconomics will tend to have its repercussions on the economy, often leading to hyperinflation brought about by the low-interest-rate environment.

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

However, there happens to be a certain time lag in noticing the desired results. The asset prices may fall, and the economy may slip into hyperinflation, and other possible risks. However, suppose 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. In that case, it will certainly produce the desired result.

This article is a guide to what is Interest Rate Effect. We explain the concept with the help of some examples, advantages and disadvantages. You can learn more about it from the following articles: -

• Formula of Real Interest Rate
• Compare - Inflation vs Interest Rate
• What is Interest Rate Risk?
• Nominal vs Real Interest Rate