Interest rates. A sometimes opaque and unclear concept which is affecting your everyday life in unimaginable ways. Understanding interest rates and the effect they have on the economy and the financial markets, and let’s be honest, more importantly to you, is of paramount importance. In today’s blog, we’ll explore how interest rates shake up economic output and drive key financial decisions.
How are Interest Rates Set? The Supply and Demand Game
At its core, interest rates are a reflection of money demand. Money demand is the total amount of cash demanded by individuals and firms in an economy, depending on what they currently want to spend, depending on current interest rates. If interest rates are high, people want to save more money in savings and investments such as bonds. The opposite is true, when rates are low, borrowing is cheap, encouraging spending and investment.
Central banks can in turn influence how much people spend in an economy by altering interest rates. If they decide to increase interest rates, this leads to a decrease in the demand for money and so more people save and invest, a rate cut will do the opposite, leading to more spending and is the typical way central banks give a kickstart to the economy.
Central banks determine interest rates by setting the supply of money in economies. The way central banks typically change the supply of money is by open market operations. If a bank wants to increase the money supply in an economy, it will buy bonds and pay for them by creating money. If it wants to decrease the money supply in the economy, it will sell bonds and take the money out of circulation.
Another key tool central banks use to manage interest rates is the repo market. In a repo (repurchase) transaction, the central bank purchases securities from financial institutions with an agreement to sell them back later. This temporarily injects liquidity into the system, effectively lowering short-term interest rates. Conversely, a reverse repo transaction does the opposite, by selling securities and agreeing to repurchase them later, the central bank absorbs liquidity, pushing short-term rates higher. These operations allow central banks to fine-tune the supply of money and keep interest rates within their target range.
These strategies fall into two categories:
- An increase in money supply leads to a rate cut, this is called expansionary monetary policy.
- Contractionary monetary policy is when banks decrease the money supply to push up interest rates.
When rates hit rock bottom and there are no other viable options, central banks have to resort to quantitative easing (QE). QE is like open market operations on steroids. Instead of making small adjustments to interest rates, central banks buy large amounts of government and corporate bonds to flood the system with liquidity, pushing borrowing costs down even further.
QE is particularly useful during economic downturns when standard rate cuts aren’t enough to stimulate growth. Central banks must eventually taper these purchases, a process that can cause market volatility if not handled carefully.
In essence, you can think of central banks as DJs, adjusting the dial on interest rates to keep the economic party from crashing or overheating.
Rates: How it affects investment, spending, and in turn the economy
Interest rates don’t just sit quietly in the background, they ripple across every aspect of the economy. We can now see how rates would affect the investment decisions of companies. A rate cut for example, would encourage firms to borrow money to make large capital investments, these investments being a key factor in determining the output of an economy, known widely as GDP. If our businesses are spending more on capital, then our economy is flourishing.
Businesses are not the only economic agents affected. Individuals like yourself are influenced massively by interest rates. If rates were at an all-time high for example, you would be saving as much as you could to take advantage of the opportunity, meaning you are consuming fewer goods. This consumption, in turn, fuels business, which is why consumption is another massive factor in determining the GDP of an economy.
This information paints a clear picture of the relationship between interest and how the economy reacts. A rate cut would lead to more money being borrowed for investment and more consumption by the people of the economy, indicating a boost to the GDP, whereas a rate hike causes less money to be borrowed for investment and more to be saved than spent, meaning the economy slows and output decreases. Now you see why central banks obsess over interest rates, they dictate whether economies thrive or dive.
The Impact on Exchange Rates
Interest plays a critical role in determining exchange rates due to their influence on the flow of capital through an economy. In general, higher interest rates attract foreign investment, increasing demand for the domestic currency and causing its value to appreciate. Conversely, lower interest rates turn off foreign capital inflows, leading to a depreciation of the currency.
One of the best historical examples of this effect occurred in the US during the early 80s. The Fed implemented a tight monetary policy to combat rampant inflation, significantly increasing short-term interest rates. At the same time, expansionary fiscal policy (increased government spending and tax cuts) boosted economic growth and further pushed up long-term interest rates.
The combination of higher interest rates and strong economic performance made American assets attractive to foreign investors, leading to a surge in demand for the dollar. This demand caused the dollar to appreciate sharply against other currencies, making US exports more expensive and imports cheaper.
This example shows how interest rate policy directly influences exchange rates, and how it can impact GDP. With exports and imports favouring the US economy, it boosted their net trade balance, another key factor in calculating economic output. If the opposite were to happen and their net trade balance decreased due to cheaper selling of exports and more expensive imports, their GDP would see a fall.
Long-Term Effects: Playing the Long Game
While short-term interest rate changes create immediate ripples, long-term effects shape economic stability. Economies naturally gravitate toward an equilibrium level of output, where resources are fully utilised without triggering runaway inflation. The natural rate of interest balances savings and investment at this point. If rates stay too low for too long, asset bubbles form and inflation spikes. If rates are kept too high, investment dries up and growth stagnates.
Governments influence long-term rates through fiscal policy. Fiscal consolidation, where the government cuts spending or raises taxes to reduce budget deficits, leads to economic contraction and lower output in the short run. In the medium run, lower interest rates encourage investment. In the long run, the economy stabilises, but with some trade-offs such as lower consumer spending.
Sustained low interest rates fuel investment, especially in infrastructure, technology, and capital-intensive industries. Over time, this boosts productivity, wages, and economic expansion. However, if rates stay too low for too long, excess risk-taking can destabilise financial markets.
Why You Should Care About Interest Rates
Interest rates are one of the most powerful tools in economic policy, influencing everything from business investment and consumer spending to exchange rates and long-term economic growth. The relationship between monetary policy, fiscal policy, and economic output is complicated, but understanding these dynamics is crucial for every reader out there.
In the short run, interest rate changes impact economic activity by encouraging or discouraging borrowing and spending. In the long run, interest rates help shape investment trends and overall economic stability.
The key takeaway? Interest rates are not just numbers on a screen. They dictate the health of economies, the strength of currencies, and the investment landscape. So, the next time you hear about a central bank rate decision, pay attention, it might just tell you where the economy (and your finances) are headed next.
