In modern economies, some individuals earn more money than they need to spend on present goods. There are other individuals who have a desire for more money than they can presently access. A natural market arises between those who have a surplus of present funds (savers) and those who have a deficit of present funds (borrowers). Savers, investors, and lenders are only willing to part with money today because they are promised more money in the future—it's the interest rate that determines how much more.
Key Takeaways
- Interest rates can determine how much money lenders and investors are willing to save and invest.
- Increased demand for loanable funds pushes interest rates up, while an increased supply of loanable funds pushes rates lower.
- Central banks, such as the Federal Reserve, manipulate interest rates to influence monetary policy.
- When interest rates are high, the cost of borrowing is higher, which results in people spending less. When interest rates are low, the opposite is true.
Supply and Demand for Loanable Funds
The interest rate describes how much borrowers need to pay for loans and the reward that lenders receive on their savings. Like any other market, the market for money is coordinated through supply and demand. When the relative demand for loanable funds increases, the interest rate goes up. When the relative supply of loanable funds increases, the interest rate declines.
The demand for loanable funds is downward-sloping and its supply is upward-sloping. The natural rate of interest in an economy balances out this supply and demand. This mechanism sends a signal to savers about how valuable their money could be. Similarly, it informs possible borrowers about how valuable their present use of the borrowed money needs to be to justify the expense.
The natural rate of interest is mostly a theoretical construct in contemporary economies. Central banks, such as the Federal Reserve, manipulate interest rates to influence monetary policy. For example, a central bank can make it cheaper to borrow and less valuable to save by lowering interest rates in the economy. These actions change the intertemporal incentives faced by economic actors.
4.6%
The U.S. personal saving rate as of May 2023.
Capital Structure and the Economy
Suppose an entrepreneur wants to start a new manufacturing company. The entrepreneur cannot start generating sales until the factors of production, such as factories and machines, are in place and operational. This production framework is sometimes referred to as the business capital structure.
Most entrepreneurs don't have enough money saved up to purchase or build factories and machines. They usually have to borrow the startup money. It can be easier to borrow money if the interest rate is low as it costs less to pay back. If the interest rate is so high that the entrepreneur isn't convinced that they can earn enough to pay it back, the business may never get off the ground.
This is how the interest rate helps determine the overall capital structure of the economy. There have to be enough savings for all of the houses, factories, machines, and other capital equipment. Additionally, the subsequent capital structure has to be profitable enough to pay back the lenders. When this coordinating process malfunctions, asset bubbles can form and whole sectors can be compromised.
Liquidity Preference vs. Time Preference
Economists disagree about the exact nature of interest rates. Interest rates have to coordinate past and future consumption, and they place a premium on risk and the safety of liquidity. This is essentially the difference between liquidity preference and time preference.
How Do Interest Rates Influence Spending?
Interest rates influence spending by making spending more or less expensive depending on the direction of interest rate movements. For example, if interest rates go up, the cost of borrowing goes up, meaning it is more expensive to buy goods, so consumer spending decreases. When interest rates fall, the cost of borrowing comes down, so it is cheaper to buy goods, so spending increases.
Do High Interest Rates Cause Saving?
High interest rates can cause an increase in savings. Because high interest rates increase the cost of borrowing, making goods more costly, individuals spend less, and thereby, save more. In addition, the return on high-interest savings accounts increases, making it more appealing for customers to deposit their money in these accounts and earn a high interest on their money.
How Does Inflation Affect Savings?
Inflation reduces the value of savings. As inflation is the increase in the price of goods across an economy, the amount of money in a person's savings account is worth less, meaning the money can't buy the same amount of goods as it could before, so its value is reduced.
The Bottom Line
Interest rates are a key component of any economy with a far-reaching impact. The level of interest rates impacts how much people save and spend. Generally, when interest rates are high, people will spend less and save more, as the cost of borrowing money to buy items such as houses and cars increases, whereas the return on savings deposits is higher. When interest rates are low, the opposite is true. The central banks of countries control interest rates either to spur the economy or slow it down.
FAQs
The level of interest rates impacts how much people save and spend. Generally, when interest rates are high, people will spend less and save more, as the cost of borrowing money to buy items such as houses and cars increases, whereas the return on savings deposits is higher.
Why is interest rate important when investing? ›
Higher interest rates tend to negatively affect earnings and stock prices (often with the exception of the financial sector). Changes in the interest rate tend to impact the stock market quickly but often have a lagged effect on other key economic sectors such as mortgages and auto loans.
How do interest rates increase investment? ›
Yes, higher interest rates tend to attract more foreign investment. That's because rising rates increase the value and demand for their own currency.
How do interest rates affect the level of saving? ›
High interest rates make goods and services more expensive due to the increased cost of borrowing through higher rates. This keeps people from spending their money, which means they are saving it. Additionally, if rates are high, consumers can receive higher returns on their savings, which further encourages saving.
How changes in interest rates will affect the amount of money that people save? ›
Higher interest rates can make borrowing money more expensive for consumers and businesses, while also potentially making it harder to get approved for loans. On the positive side, higher interest rates can benefit savers as banks increase yields to attract more deposits.
How interest rates affect investment and savings? ›
The level of interest rates impacts how much people save and spend. Generally, when interest rates are high, people will spend less and save more, as the cost of borrowing money to buy items such as houses and cars increases, whereas the return on savings deposits is higher.
How does raising interest rates help us? ›
Higher interest rates increase the return on savings. They also make the cost of borrowing more expensive. Higher interest rates help to slow down price rises (inflation). That's because they reduce how much is spent across the UK.
What does the interest rate increase mean for investments? ›
Key Takeaways
Higher interest rates also mean future discounted valuations are lower as the discount rate used for future cash flow is higher. To shield from risk, investors may consider opting for shorter-term bonds or shorter life alternative assets.
How do real interest rates influence investment? ›
Higher real interest rates can increase borrowing costs. This can cause people to curb spending and borrowing. This, in turn, can slow economic activity. Of course, higher real interest rates can also improve the returns people may earn on their investments.
What is a good interest rate for an investment? ›
What is a good rate of return?
| Asset Type | Compound Annual Growth Rate (CAGR) |
|---|
| Small-cap stocks | 11.9% |
| Large-cap stocks | 10.2% |
| Government bonds | 5.5% |
| Treasury bills | 3.3% |
1 more rowNov 10, 2023
The benefits of higher interest rates
Higher interest rates can be good news. The savings in a "high-interest" bank account could grow faster. Also, many fixed-rate investments, like guaranteed interest options or guaranteed investment certificates (GICs), could give you higher returns.
Who benefits from high-interest rates? ›
The financial sector generally experiences increased profitability during periods of high-interest rates. This is primarily because banks and financial institutions earn more from the spread between the interest they pay on deposits and the interest they charge on loans.
What is the relationship between interest rates and investment? ›
Interest Rate-Investment Relationship
When interest rates are high, it becomes more expensive for businesses to borrow money to invest, which tends to reduce investment spending. Conversely, when interest rates are low, borrowing costs are lower, which encourages businesses to invest more.
Does interest increase or decrease money? ›
Increasing interest rates does not increase a nation's money supply because the two have an inverse relationship. Higher interest rates translate to a lower supply of money in the economy.
Why are interest rates important? ›
An interest rate is the cost of borrowing money. Or, on the other side of the coin, it is the compensation for the service and risk of lending money. In both cases, it keeps the economy moving by encouraging people to borrow, to lend, and to spend.
How to profit from rising interest rates? ›
8 money moves to make as interest rates remain high
- In a nutshell. ...
- Search for banks with the best savings accounts. ...
- Keep an eye on credit card interest. ...
- Refinance a mortgage (it's not too late) ...
- Invest in stocks. ...
- Consider Treasury Inflation-Protected Securities (TIPS) ...
- Buy short-term bonds instead of long-term bonds.
Real interest rates give savers, investors, and borrowers insight into their purchasing power by allowing them to compare the real interest rate to the inflation rate. They provide an idea of how much they'll earn from an investment or savings account.
Is a higher interest rate better for investing? ›
Higher interest rates can be good news. The savings in a "high-interest" bank account could grow faster. Also, many fixed-rate investments, like guaranteed interest options or guaranteed investment certificates (GICs), could give you higher returns.
What is the importance of interest rate? ›
Interest rates go a long way in determining the geometry of the economy, meaning the actual distribution of labor and resources. It matters which industries grow and which industries shrink, and where people are deploying financial and physical capital. Interest rates guide much of that movement.
