How Do Interest Rates Affect the Economy?

Interest rates are an economic variable that affect all segments of the economy. Consumers feel their impact whether making a purchase on credit or buying a home. Businesses factor interest rates into their decisions to finance inventory or invest in new equipment. And government finance is heavily impacted by interest rate levels.

Interest rates are determined by the supply and demand for money, which are influenced by a variety of market forces. The most important of these are the policy actions of the Federal Reserve, which actively manages the rates that banks pay when they need money. Banks must borrow if their reserves fall below required levels. They can borrow from each other or from the Federal Reserve, and the Fed sets both rates – the Federal funds rate and the discount rate, respectively. When these rates go up, the rates banks charge their customers go up, too. The process is not instantaneous – it may take up to 18 months for the full impact to be felt throughout the economy.

Rising interest rates increase the cost of borrowing money, which reduces the amount of borrowing. Savings rates are likely to increase as people find they can earn higher returns on their savings. Mortgage rates rise, hurting first-time home buyers as well as those with adjustable rate loans. Businesses, too, find borrowing more expensive. Expansion plans may be put on hold, and lines of credit for financing inventories become more expensive. Customer purchase made on credit also decline, hurting business sales.

When interest rates fall, people have less incentive to save. Borrowing becomes more affordable, and both consumers and businesses are likely to increase their debt. With increased spending by consumers and businesses, lower interest rates are bullish for the national economy. Lower interest rates bring lower mortgage rates, which lower monthly mortgage payments. This stimulates the housing sector, which is critical for national economic growth. In fact, if the economy is weak or in a recession, the Fed's policy is to cut interest rates to stimulate growth.

Interest payments on the national debt pose a significant threat to the economy should rates rise. As the national debt rises, the federal government borrows, issuing both short-term and long-term securities. When Treasury notes and bonds mature, they are rolled over to new notes and bonds at the prevailing rates. As long as rates remain low the interest payments remain manageable. But if interest rates rise, debt service will grow – both in absolute terms and as a percentage of the federal budget.