How Do Interest Rates Influence the Economy?
Interest rates may seem like a simple number set by the central bank, but they typically affect everything, from borrowing money to buying a house to the strength of your country’s currency.
Let’s break down why central banks adjust rates and how that impacts the economy.
Why do central banks change interest rates?
1. When the economy is growing too fast
When businesses are thriving, unemployment is low, and consumer spending is high, it can contribute to economic growth; however, it may also lead to inflation if prices rise too quickly.
To maintain economic stability, central banks may raise interest rates. This makes borrowing money more costly, which typically slows down spending and borrowing. This approach aims to slow the economy before inflation escalates.
2. When the economy is slowing down
If businesses are struggling, people are losing jobs, and consumers are cutting back on spending, the economy needs a boost.
In this instance, central banks usually cut interest rates. Lower rates mean more affordable loans, which encourages spending, investing, and borrowing – helping fuel growth and avoiding a recession.
For example, in 2016, the Bank of England lowered interest rates to 0.25% in response to the economic uncertainty following the Brexit vote.
Effects of higher interest rates
Borrowing gets expensive
Loans and credit cards cost more, so fewer people and businesses borrow money.
Spending drops
Higher repayments mean less disposable income, so people spend less on goods and services.
Business confidence shrinks
Companies may hold off on hiring or investing because it’s harder to finance growth.
Stronger currency
Higher rates attract foreign investors, which can boost demand for the local currency and make it stronger.
Effects of lower interest rates
Borrowing gets cheaper
People are more likely to take out loans – boosting home buying, car sales, and investments.
Asset prices rise
With easier access to credit, the prices of homes and other assets can increase.
Spending increases
More disposable income means more spending, which keeps the economy moving.
Weaker currency
Lower rates may encourage investors to look elsewhere for better returns, which can weaken the local currency.
Conclusion
Interest rates are among the most powerful tools at the disposal of central banks. When rates are raised to slow the economy or lowered to spark growth, the impact is felt throughout the entire economy, from mortgage payments to the strength of the currency.
Understanding how they work can help you make smarter decisions, whether you are managing your savings, running a business, or trading the markets.
Interest rates may seem like a simple number set by the central bank, but they typically affect everything, from borrowing money to buying a house to the strength of your country’s currency.
Let’s break down why central banks adjust rates and how that impacts the economy.
