Effect of Change in Interest Rates

In today’s world, most big industries fancy taking a loan for any investment and purchase, and most households have some kind of money lent either way from any of the organisations or banks. Thus, we can see how most households’ businesses, and even sometimes countries, can be affected by the change in the rate of interest. The interest rates in our country are quoted by the Reserve Bank of India. The Reserve bank also holds power to increase the rates when it predicts an inflation growth corresponding to its inflation threshold. The change in interest rates can also lead to a change in inflation.

Effects Of Change In Interest Rates

There can be adverse to moderate effects of the change in interest rates. For example, when the interest rates are increased, a moneylender’s profit goes up, as the cost of the loan shoots up, and they receive more interest on the same amount of principal. On the other hand, a person who has borrowed the money would suffer a loss as they would have to pay more of the interest amount. 

Let us now see how the economy is affected if the interest rates go higher:

Effects Of Higher Interest Rates

1. The cost of borrowing money increases: If the interest rates increase, the money to be paid on interest will increase. This means that credit cards and loans become way more expensive than they were initially. This situation will result in a decrease in attempts to take loans by people and industries. Many money lending organisations might see a downfall in the number of people and industries that take money from them to avoid the risk of having to pay such high interests. Companies that take loans from the banks for investments also become more conscious of taking any unnecessary risks in such a scenario. This will eventually lead to a decrease in investment in general, resulting in slower economic growth.

   During higher interest rates, even countries exercise more caution while taking loans from the World Bank for various development programs as it might lead to the deceleration of the pace of development.

2. Increase in the amount of mortgage interest- In India, the amount of mortgage taken is quite a lot. There are a lot of loans taken for the real estate business. In the case of higher interest rates, the real estate business will have two different effects – one good and one bad.

   The good effect is the rates of houses may drop; thus, homes will be available at cheaper rates. The bad effect is that higher mortgage interest payments increase the amount of consumption in households and firms. The expenditure on research and development must be reduced as households and firms would be more focused on the loan payment, eventually leading to the slower economic growth of a company and an individual or household.

3. People with fixed and recurring deposits will receive more interest: During higher interest rates, people who have fixed deposits and recurring deposits will receive a greater rate of interest on the return of their deposits. But with this, people will be more focused on saving than on spending, which will reduce the amount of consumption and increase the amount they save in the banks such as FDs and RDs. This might not adversely affect the economy on a large scale, but will see a slight effect in the taxes collected from the purchase of goods, thus collectively affecting a country’s pace of economic development.
4. Increase in the value of the currency: A country experiencing a higher interest rate will attract the attention of foreign investors as due to a high rate of interest, the return will be significantly elevated. This, in turn, will increase the value of that country’s currency in the world market. But this can adversely affect the export-import business of that country, as the more the value of the currency, the less the world market is prone to export from that country. The world market will instead choose to import more into that country and receive more profit (as the currency’s value is increased) than to export to that country and pay more for the same quantity of material. This will adversely affect the export and import business of the country, thus, affecting the economy of that country.

   For a superpower like China, on which the world is dependent for so many vital materials, their export is mandatory. Higher interest rates will surely profit them as their export is inevitable, and the countries have to pay the quoted amount.

5. Other miscellaneous effects:

1. Both consumers and firms will be affected by the interest rates, and there might be a significant downfall in the rate of consumption and investment.
2. Higher taxes may be imposed on the affected country by the governing bodies as the country will be annually paying more interest and loans to the world banks. To compensate for the increased payment, they might increase the taxes paid by the citizens.
3. The inflation will be lowered.
4. Overall, borrowers will be less confident to take loans and pay such a high-interest amount. This leads to a drop in the rate of investment.

Conclusion

We can see how a simple increase in the interest rate can hit the whole economy, profit the money lenders and attract foreign investors, and somehow help the country economically. Still, it is all a matter of perspective. A change in the interest rate can affect every aspect of a nation’s economy, starting from household expenditure and investment to development programs initiated by the government for the country. 

The increase or decrease in the interest rates can also bring a significant change in how things work in a country. They may increase the currency appreciation of that country or even increase the taxes paid by the citizens, thus making everything in the country expensive. This will result in less consumption and lead to slower economic growth, or can alter the rate of inflation. Therefore, the rate of interest holds a major power to change the financial system of a nation.