Interest Rate EffectDefinition and Examples

Written By:
Lisa Borga

The national interest rate is changed periodically to try to ensure sustained economic growth.

This rate is set by government departments, including the United States Federal Reserve.

When this interest rate is changed, sometimes consumers, banks, and others will change their behavior as well.

The changes in behavior resulting from interest rate adjustments are called the interest rate effect.

The Interest Rate Effect

The interest rate effect refers to the changes that occur in behaviors such as spending and borrowing after a change in the interest rate.

Typically, after the U.S. central banks set an interest rate, other banks will offer similar rates to their customers.

However, these banks will charge more interest to make a profit.

If the central banks lower their interest rates, consumer banks will lower rates as well.

When this happens, individuals and businesses well generally borrow more money.

This happens because it will cost less to borrow money since interest payments will be lower.

The Interest Rate Effect and Aggregate Demand

How interest rates affect aggregate demand is considered an important part of macroeconomics.

Macroeconomics studies the economy as a whole, so it deals with how economies perform.

The aggregate demand for a country is the value of the country’s goods and services at a specific price point.

Generally, when prices increase, demand will fall due to the fact that fewer people want to buy the higher-priced goods.

In contrast, when prices fall, consumers will have more money to buy goods, and thus demand will increase.

The Formula for Interest Rate Effect

This is the formula for calculating aggregate demand:

C + I + G + (X-M) = Aggregate Demand

Where:

C = Consumer Spending

I = Investment in Capital Goods

G = Government Spending

X – M = Net Exports

The Effect of Interest Rates on Aggregate Demand

When the government increases interest rates, it is more expensive to borrow money; thus, fewer people are likely to do so.

Therefore, since most of the money being borrowed is likely to be used for consumer expenditures as well as capital investment, these two sectors will decline when interest rates are high.

This means that aggregate demand will decline as well, as shown by the equation for aggregate demand.

If interest rates decline, there will be an opposite effect.

Individuals and businesses want to borrow more money at lower interest rates and invest this money in capital and consumer purchases. Therefore aggregate demand will increase.

However, when interest rates are higher, the central banks make more money from the interest payments they receive from borrowers.

This means that the government is getting more money for its expenditures.

But, macroeconomists have found that even with possible increases in government spending, it is generally not enough to make up for the decline in capital investment and consumer spending.

So, the increased government spending typically does not cause a positive change in aggregate demand.

Interest Rate Effect Example

The housing market is a good example of how the interest effect works.

For many people, a home will be one of their biggest investments.

Most Americans do not have enough money to pay cash for their house; therefore, they will take out a loan from a bank.

This means they will have to pay the bank interest on the loan,

Suppose the consumer buys a home for $300,000.

The consumer puts a down payment of $60,000 on the home and takes a loan out for the remaining 240,000 at a 3% adjustable interest rate.

The consumer would pay the bank $7,200 a year in interest.

However, this amount would likely decrease as the principle of the loan decreases.

But, the interest rate that the consumer pays could change if the Federal Reserve changes the interest rate.

If the Federal Reserve increases the interest rate by .20%, commercial banks would be required to pay more to borrow money.

Therefore, these banks would charge consumers more to borrow money as well.

At this new interest rate, the consumer in our example would be required to pay $7,680 per year in interest.

The increase in interest borrowers will have to pay if they purchase a home could cause some consumers to put off buying a home.

If enough consumers decide to put off homeownership, it could cause a decrease in aggregate demand.