Understanding Business and Consumer Economic Behavior when Interest Rates Decrease and Increase
When interest rates decrease, do businesses and consumers change their economic behavior? According to the Austrian Theory of the Business Cycle, a decline in interest rates leads to higher borrowing for businesses and less savings for consumers.
Therefore, the movement of interest rates, whether up or down, impacts the consumers and businesses or producers.
What Causes Interest Rates to Decrease?
Central banks determine the standard for interest rates used by banks, which are referred to as the benchmark rates. According to Investopedia, an interest rate moves the economy as it pushes people to spend, lend, or borrow. It is defined as the risk of lending money and payment for the service.
The movement of interest rates affects a credit's supply and demand. A decrease in the rates means a decline in a credit's demand, and higher interest rates mean an increase in the demand for credit or money.
The change in the interest rates is affected by the supply and demand influenced by monetary policy and inflation.
When Interest Rates Decrease, Do Businesses and Consumers Change their Economic Behavior?
Let's look at how the lower interest rates will affect the consumers and their impact on the economy:
When interest rates go down (e.g., from 10% to 5%), it will discourage people from saving their money. Why? Because before it went down, they were getting 10% savings returns, but now it is cut in half.
However, the decrease in interest rates encourages borrowing money since it is now cheaper since you will only be required to pay 5%. The action of borrowing money is like renting that money. This means you only need to pay a 5% rental fee in this sample.
These effects of the decrease in interest rates - discouraging saving and encouraging borrowing; equate to more money going into the economy.
When there is more money in the real world or the economy, it will result in more demand for services and goods. This scenario will affect the following:
Luxury goods
The decrease in interest rates will cause an increased demand for luxury goods since the economy has more money.
Higher employment rate
Since there's an increased demand for goods, businesses will be prompted to produce more. So they will need more staff to produce more goods, which will cause them to hire more people.
Let's see the effects of the low-interest rate on the part of the businesses or producers:
How will the interest rate decrease further affect businesses or producers? It will become cheaper to borrow money.
As a business, when you know that it is less expensive to borrow money, you are likely to maximize the situation by investing. You will expand your investment portfolio since you can afford to because you can borrow higher money and pay less than usual interest rates. This is a good time to invest in something that will benefit the business, like a new shop, a new factory, and so on.
When businesses invest more, it will lead to more production, meaning you will make more things as a business or producer. You will then need more people to manufacture more things, so it will create more jobs.
As a result, people who used to earn less or none will have an income, and those who used to earn a stable income will have more money. When people have more money, they will become more able to spend, which will then boost the economy.
What Will Happen to Consumers and Businesses When Interest Rates Increase?
Let's look at the scenario when the opposite happens, and the interest rates increase (e.g., from 5% to 10%).
Here is how it will affect the consumers:
When interest rates go up, more people will get inclined to save because they will get more when they leave their money in the bank.
However, you will be discouraged from borrowing money since you will be asked for a higher interest rate when applying for a loan.
The economy will have less money when consumers save more money and borrow less. When the economy is down, it creates less demand for the services and goods provided by producers or businesses. So there will be less demand for luxury goods.
This is bad for the producers since they will cut down the numbers of their products, meaning they will need fewer people to continue operating. This will lead to redundancies. Since fewer people are needed for businesses to operate since they aren't making enough sales, more people (consumers) will lose their jobs, increasing the unemployment rate.
Let's now look at how higher interest rates affect the producers or businesses and the economy in general:
When interest rates go up, it will be more expensive for producers or businesses to borrow money. This will make them less likely to invest and/or postpone any investments they may have planned to make.
Higher interest rates will also push a public limited company or a private limited company to utilize equity for finance.
Interest rates going up or down will affect the behavior of consumers and businesses. However, the movement will have a limited impact on producers or businesses dealing with essential goods or services, which means the basic necessities.
For example, consumers will still buy food no matter what the current interest rate is. They will continue purchasing medicine and they will continue going to the doctor when they are sick.
So the movement of interest rates will largely affect the goods or services considered as not essential or the luxury goods, such as new gadgets/devices or new cars.
The Bottom Line
The effects of the movement of interest rates on consumers and businesses will depend on the size of the interest rate change. If it only goes up or down from 1 to 2%, both consumers and businesses will likely continue with their usual spending and borrowing behaviors.
This means that the bigger the increase or decrease of the interest rates, the bigger the impact they will have on the behavior of consumers and businesses, which will, in the end, affect the economy.
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