A Guide To Interest Rates

A guide to interest rates

The objective of this article is to provide a detailed explanation of the importance of interest rates and how they impact upon the borrowing and saving activity of any individual. Furthermore, we will discuss how changing interest rates influence the economy as a whole, whilst identifying other consequences they have on the activities of individuals.

How interest rates affect Borrowing

Simply put, the rate of interest indicates how much it will cost you to borrow money. If you are quoted an interest rate of 10% over a period of 12 months, at the end of this period you will simply have to pay 10% of the money you borrowed in interest, on top of the full amount you owe.

Consider the following example: What will be the total cost at the end of 12 months to an individual who borrows £100 at an interest rate of 10%? Ten percent of £100 is £10, and therefore at the end of 12 months the individual will owe £10 in interest. It is pretty much as easy as that. Obviously this is a very basic example, but the general idea applies to all circumstances.

It is therefore obvious that the higher the rate of interest, the higher the repayments of borrowed funds will be for an individual, making it less attractive to borrow money. The opposite applies however, when we consider saving money. Also, one of the positives of borrowing money is that you pay no tax on the borrowed funds. You simply pay back the money you owe, to which the government has no access.

How interest rates affect Saving

We can describe the impact of interest rates on the saving activity of individuals in a similar way as we did for their borrowing activity. When you are saving money, you are essentially lending money to your bank. The bank is free to do what it wants with your money until you claim it back. Therefore, in this case the rate of interest is how much it will cost the bank for borrowing your money.

Consider the following example: What will you receive at the end of 12 months if you lend the bank £100 at an interest rate of 10%? Ten percent of £100 is £10, and therefore at the end of 12 months the bank will owe you £10 in interest. Again, it is a pretty simple concept to grasp.

In the case of saving, unlike borrowing it is obvious that the higher the interest rate, the more attractive it becomes to save money by putting it in the bank.

How interest rates affect the economy as a whole

Interest rates can have an impact on many components of the economy. Specifically, it has a direct influence on Aggregate Demand. Aggregate Demand is comprised of 5 elements: Consumption, Government Expenditure, Investment, Exports, and Imports. Let us consider how interest rates affect each of these.

The higher the interest rate, the more expensive it becomes for consumers to buy durable goods (washing machines, televisions etc) since repayments over a period of time will increase. This will lead to a fall in consumption, and therefore a fall in the aggregate demand. Furthermore, the output of the economy will decrease.

Such a scenario also applies to government expenditure and investment. That is, a rise in interest rates will cause a decline in both of these components, therefore leading to a fall in aggregate demand and in turn a fall in national output. How does this work? A rise in interest rates means that it becomes more difficult for the government to spend money on the economy. The government borrows money from the Bank of England when funding its national spending, and as we know from our analysis of the impact of interest rates on borrowing, it becomes much more costly to borrow money when interest rates increase. Investment activity is hurt by rising interest rates for the same reason. In order to support an investment, companies or enterprises will borrow money.

Finally we look at the impact of interest rates on exports and imports. The value of a currency is determined by the rate of interest. Simply put, the higher the rate of interest, the higher the value of a currency. This will lead to a fall in exports and a rise in imports, ultimately leading to a decline in aggregate demand. How does this work? An increase in the value of the pound against other currencies means that it is more expensive for foreigners to buy the pound. Products from the UK become more expensive, and exports will consequently suffer. On the other hand, the higher the value of the pound, the cheaper other currencies will become against the pound. This means that products from outside the UK become cheaper meaning it becomes more attractive to import products into the UK.