What Is Interest Rate Effect?

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on March 29, 2023

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Interest Rate Effect Definition

The interest rate effect refers to the effect of an increase or decrease in aggregate demand in an economy due to changes in interest rates set by the central bank of a country.

Interest rates have an inverse relationship with aggregate demand.

When rates are high, demand is low and vice versa.

These changes in demand affect consumer expenditures and the state of the overall economy.

Interest Rate Effect Explanation

A country's central bank is responsible for setting the interest rate at which it lends money to banks.

The rate setting ripples through an economy through banks and other financial institutions that lend to businesses and consumers.

Together, these institutions use interest rates to calibrate the economy's velocity and stimulate or tamp down on demand, as the case may be:

  • High interest rates have a contractionary effect on an economy because they increase the cost of borrowing.

    With less money circulating in the system, people are discouraged from spending and consumer demand for goods and services falls.

  • Low interest rates have the opposite effect of high interest rates. They speed up an economy by making it easy to borrow from banks.

    There is more money in the system and people are encouraged to spend and consumer demand for goods and services rises.

Interest Rate Effect Example

Suppose a home loan borrower has an adjustable rate mortgage that charges a 10% annual interest rate on a loan of $200,000.

The borrower will have to pay $20,000 in the first year.

The Federal Reserve slashes rates by one percentage point the next year.

The mortgage issuing agency decides to pass on the entire savings to the borrower and adjusts rates to 9%.

This means that the borrower will have to pay $18,000 in interest payments next year, leaving them with $2,000 more cash to spend on other goods or services.

Positive vs Negative Interest Rates

While we know the effect of high and low positive interest rates on an economy, the consequences of having negative interest rates are still being documented.

Japan and Switzerland are two prominent countries which have introduced negative interest rates in recent times.

Negative interest rates have a positive effect on exporters because the local currency is devalued and becomes cheaper.

But it is still an open question as to whether negative interest rates can induce economic growth by encouraging consumers to spend money.

Interest Rate Effect FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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