Interest Rate Effect Definition

The interest rate effect refers to any changes that the macroeconomic environment undergoes because of direct repercussions caused by certain changes in the country’s interest rate.

  • Suppose an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more is overheating and constantly rising from 2% to 7%. Then, naturally, it will raise the interest rate in the economy, and this will try to bring down inflation in the economy.Similarly, suppose the inflation is falling in the economy from 5% to 2%, and the government feels a significant need to boost the economy. In that case, they may reduce the interest rates to borrow at a reduced rate and thus grow. Again, it provides a stimulus for economic expansion.

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Advantages of Interest Rate Effect

Given below are examples of how interest rates affect inflation tends to benefit: –

Disadvantages of Interest Rate Effect

There are certain disadvantages of the interest rate effect on inflation: –

  • Time lag – Even if the interest rate changes have been taken, it does require a significant amount of time for the interest rate effect to be visible in the economy. As a result, the impact of changes may take months or even sometimes years to even reflect and even materialize.Affect the Whole Economy: Including the Untargeted Sector – The interest rate effect is a macroeconomic tool that impacts the whole economy and does not consider that some parts or sectors do not warrant or require such stimulus. It is also well known that the monetary policy tool Monetary Policy ToolMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more being interest rate cannot be targeted to solve problems of a single sector or, even boost a specific industry or region.Technical Limitations – The rate in the economy can only be lowered to a low of zero, beyond which the interest rate effect may not be able to play its desired role. If the interest rates are kept low for a relatively long period, it may often lead to a liquidity trap Liquidity Trap The liquidity trap is a scenario where the interest rates fall. Yet, the savings rate goes high, which tends to bring about ineffectiveness to the objective of expansionary monetary policy to increase the money supply. In this situation, people prefer holding cash rather than bearing a debt leading to virtual omission of liquidity from the market.read more for the country.Reduction in Asset Prices – An increase in interest rate would reduce the valuation of financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more like stocks and bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more. The interest costs increase, which eats out into the business’s income. That causes the earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more to decline, and the repercussions are now felt in the stock prices, which then fall.The Possible Risk of Hyperinflation – When interest rates in the economy are at a really low level, there are chances that over-borrowing at artificially cheap rates may go on to cause a speculative bubble in the economy where prices may climb artificial high levels. When more money is pumped into the economy, it may cause out-of-control inflation. When there is more money available in circulation, the value of each unit of money may at times decrease due to the high level of demand. That is how the interest rate effect will tend to have its repercussions on the economy, often leading to hyperinflation brought about by the low-interest-rate environment.

Limitations of Interest Rate Effect

  • It can reduce the interest rate to a low of zero, beyond which the interest rate effect may not come into play.

Conclusion

The Central Bank uses the interest rate effect to bring about the changes in the economy to have it moved in the desired direction. Therefore, it does serve as an important tool to bring the economy towards its stable state by providing the desired stimulus through such actions. As a result, the exports in the country receive a boost.

However, there happens to be a certain time lag in noticing the desired results. The asset prices may fall, and the economy may slip into hyperinflationHyperinflationHyperinflation is merely an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services, and it causes people to lower their holdings in that particular currency as they opt to participate in foreign currencies that are relatively more stable.read more, and other possible risks. However, suppose the Central Bank tends to plan out a robust full-fledged plan to have the interest rate achieve the desired results after considering the negative points. In that case, it will certainly produce the desired result.

This article is a guide to Interest Rate Effect definition. Here, we discuss the interest rate effect on inflation, its advantages, and its disadvantages. You can learn more about it from the following articles: –

  • Formula of Real Interest RateCompare – Inflation vs Interest RateWhat is Interest Rate Risk?Nominal vs Real Interest Rate