How Interest Rates Affect the Economy: A Simple Guide for Everyone

You may have heard that the Central Banks have been raising interest rates for some time.

But do you know why they are doing this and how it affects you and the economy?

In this blog post, I will explain the basics of how interest rates work and how they influence economic activity and inflation.

By the end of this post, you will have a better understanding of one of the most important tools of monetary policy.

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What are interest rates and why do they matter?

Interest rates are the prices that borrowers pay and lenders receive for lending and borrowing money. They affect how much money people and businesses have to spend or save, and how much it costs to invest or borrow.

Interest rates also affect the value of assets like houses, shares and bonds, and the exchange rate of currency.

The Central Bank sets the Overnight policy rate (OPR), which is the interest rate that banks pay to borrow from each other overnight. The rate influences other interest rates in the economy, such as mortgage rates, deposit rates, bond yields and business loan rates. The Central Bank uses the interest rate to achieve its inflation target of 2–3 per cent over time. This means that the Central Bank wants the prices of goods and services to increase by 2–3 per cent on average each year.

How does the Central Bank use the interest rate to control inflation?

The Central Bank changes the interest rate to affect the demand for goods and services in the economy. When demand is too high, it can cause inflation to rise above the target range. When demand is too low, it can cause inflation to fall below the target range. The Central Bank tries to balance demand and supply by adjusting the interest rate.

When inflation is too high, the Central Bank raises the interest rate to slow down demand. This makes borrowing more expensive and saving more attractive, which reduces spending and investment. It also lowers asset prices and increases the value of the currency, which makes imports cheaper and exports more expensive. These effects reduce inflationary pressures in the economy.

When inflation is too low, the Central Bank lowers the interest rate to boost demand. This makes borrowing cheaper and saving less attractive, which increases spending and investment. It also raises asset prices and decreases the value of the currency, which makes imports more expensive and exports cheaper. These effects increase inflationary pressures in the economy.

How long does it take for changes in the interest rate to affect the economy?

The effects of changes in the interest rate are not immediate or uniform. They depend on how people and businesses react to them and how they influence their expectations about future interest rates, income, prices and economic conditions. The effects also vary depending on how much debt or savings people have, what type of debt or savings they have (fixed or variable), and what assets they own.

The first step is from the interest rate to other interest rates and the exchange rate. This happens quickly, usually within days or weeks.

The second step is from interest rates and the exchange rate to economic activity. This happens through five main channels:

• The cash-flow channel: Higher interest rates reduce the income that borrowers have left after paying their debt, which reduces their spending. Lower interest rates increase their income and spending. The opposite happens for savers.
• The intertemporal substitution channel: Higher interest rates increase the incentive to save now and spend later, which reduces current spending and investment. Lower interest rates decrease this incentive and increase current spending and investment.
• The asset-price channel: Higher interest rates lower asset prices, which reduces household wealth and spending. Lower interest rates raise asset prices, which increases household wealth and spending.
• The credit channel: Higher interest rates make lending more risky and costly, which reduces the supply of credit to households and businesses. Lower interest rates make lending less risky and costly, which increases the supply of credit.
• The exchange rate channel: Higher interest rates increase the value of the Australian dollar, which reduces import prices and export competitiveness, which reduces inflation and spending. Lower interest rates decrease the value of the Australian dollar, which increases import prices and export competitiveness, which increases inflation and spending.

This step takes longer, usually several months or quarters.

The third step is from economic activity to inflation. This happens when changes in demand affect how much firms can charge for their goods and services, how much they pay for their inputs (such as wages), and how much they produce (which affects their costs). This step takes even longer, usually one or two years.

What has been happening recently?

Since May 2022, the Central Banks have raised the cash rate by different measures such as 400 basis points (or 4 percentage points) or from 0.1 per cent to 4.1 per cent. This is because inflation has been too high, mainly due to supply disruptions caused by COVID-19 that have increased costs for many goods and services. The Central Bank wants to bring inflation back into its target range of 2–3 per cent.

These increases in the interest rate have been transmitted to the economy through the five channels we described above. The most noticeable effect has been on the cash-flow channel, as households and businesses with variable-rate debt have faced higher interest payments, which have reduced their income and spending. This has been partly offset by higher interest income for savers, but not enough to prevent a slowdown in demand growth.

The other channels have also been at work, but with different degrees of strength and timing. The intertemporal substitution channel has reduced spending and investment, especially in housing, as people have postponed their plans to a later date. The asset-price channel has lowered housing prices, but not by much, as population growth and low supply have supported demand. The credit channel has reduced the availability of loans, especially for new borrowers, as banks have tightened their lending standards. The exchange rate channel has had a small effect, as the Australian dollar has depreciated slightly against other currencies, reflecting global factors as well as domestic ones.

The Central Banks are monitoring the economic developments closely and may need to raise the interest rate further to ensure that inflation returns to its target range in a reasonable timeframe.

Key takeaways:

• Interest rates are the prices that borrowers pay and lenders receive for lending and borrowing money. They affect how much money people and businesses have to spend or save, and how much it costs to invest or borrow.
• The Central Bank sets the interest rate to achieve its inflation target of 2–3 per cent over time. When inflation is too high or too low, the Central Bank changes the interest rate to affect the demand for goods and services in the economy.
• Changes in the interest rate affect the economy through five main channels: the cash-flow channel, the intertemporal substitution channel, the asset-price channel, the credit channel and the exchange rate channel.
• The effects of changes in the cash rate are not immediate or uniform. They depend on how people and businesses react to them and how they influence their expectations. They also vary depending on how much debt or savings people have, what type of debt or savings they have, and what assets they own.
• The Central Banks have raised interest rates to slow down demand and reduce inflation, which has been too high due to supply disruptions caused by COVID-19. These increases have been transmitted to the economy through the five channels, with different degrees of strength and timing.

P.S. How has your understanding of interest rates changed after reading this blog post? Share your thoughts in the comments below! #InterestRates #Economy

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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