The effect of interest rates on the economy

Nearly every beginning to intermediate macroeconomics textbook repeats a similar mantra: central banks decrease interest rates to stimulate an economy, and increase rates to slow it down. Few resources begin to touch upon the complicated channels by which interest rates actually affect an economy, the conditions under which those channels work or don’t work, and the time frames within which they are likely to have an effect.

This site is dedicated to documenting and receiving comments on the question of the effect interest rates have on an economy, and in particular how. As can be seen below, the channels are rather complicated, with the net effect not always clear. Those channels where interest rate effects are consistent with policy are in green, inconsistent is in red, and neutral is in grey. Leave comments below. Additional channels will be added as they are brought to my attention.

This question is separate, but related to perhaps an even more interesting and relevant question: the extent to which central bank policy rates actually affect other rates in an economy. That topic will be explored in more detail in the blog entries.

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Channel

Comments on Channel

Affect GDP through the “C” or consumption component of GDP, I

If consumers are willing to borrow more to consume and banks are willing to lend (not always clear, see related blog entry), lower interest rates can help increase consumption and GDP. Higher rates had lower consumption. After a credit crisis, like in 2008, banks may not be able (due to regulations or capital requirements) or willing (after getting burned) to lend and consumers may be shedding debt, so effects are muted. Higher interest rates may not decrease borrowing, if credit standards are low and/or if demand increases for other reasons. Easy money that is not cheap, can still spur borrowing.

Affect GDP through the “C” or consumption component of GDP, II

Lower interest rates increase prices of bonds and can have a secondary inflationary impact on other assets as investors leave bonds for other asset classes in search of yield. An increase in broad asset prices can have a wealth effect where people feel richer and spend more, increasing economy-wide consumption. This would affect those with large investment portfolios more than the middle class and below. The wealth effect is mitigated by higher income groups’ observed lower propensity to consume. Higher rates can lead to lower asset prices, reversing this effect.

Affect GDP through the “C” or consumption component of GDP, III

If rates are low, all other things equal, consumers may decide to consume in the present period rather than save at low rates. Higher rates may spur more saving and less investment. This assumes that the policy rate affects other rates in the economy.

Affect GDP through the “C” or consumption component of GDP, IV

Lower interest rates can decrease income from fixed assets, and decrease their accumulation and anticipated retirement income, causing people to consume less both in retirement and while saving for it. This is the flip side of the asset value increase of the wealth effect. It mainly affects older consumers, who are an increasing percentage of the population, and/or those reliant on insurance products whose payouts are also at risk from low rates. This effect may also cause retirees to put off retirement, potentially putting downward pressure on wages and consumption in other parts of the economy.

Affect GDP through the “C” or consumption component of GDP, V

Interest rates affect many fixed asset prices, particularly housing, small business purchases, and small business leases. Effects are complex, but higher costs of such assets can lead to more saving and less consumption to reach the hurdles required for acquisition. This can cross generations, as family members save to help other family members make the purchases.

Affect GDP through the “I” or investment component of GDP

Lower interest rates lower investment costs by definition. This can lead to increase investment if: an investment all other things equal still yields a good return, which is less likely during a weak economy when low interest rates prevail; companies adjust their WACC to the new rates, which evidence indicates they may not; businesses need capital to invest, as many small businesses operate and invest on retained earnings, and; investment capital is available, which it may not be due to bank and regulatory policies following a recession. Higher interest rates may or may not lead to less investment, for many of the same reasons.

Affect GDP through the “I” and “C” components of GDP, through company spending

Companies with high debt may find their cost of borrowing changing with interest rates. This may increase or decrease profit, possibly changing investment patterns or shareholder distributions, driving changes in both economy wide investment and consumption. Many companies post-2008 retained profits or borrowed at low rates to buy back their shares to boost stock prices. The latter can have a wealth effect if stock prices rise, but may have the opposite effect if rates rise on newly highly indebted companies.

Can affect capital movements in and out of an economy, thereby affecting other rates, real incomes, and investment. Works through the “C,” “I,” and “G,” components of GDP.

Very complicated affects through multiple possible channels. Lower rates tend all other things equal to lead to a lower currency value, which can lead to increased exports and “C,” but also to lower real incomes from increase export prices especially for non-reserve currency economies. Rates low relative to other economies can ironically lead to capital flight, and less capital available for investment, leading to downward pressure on “I.”

Change in the “G” component of GDP, through interest rate and consequent policy effects

Changes in interest rates can influence the tendency to take on debt. Though rates change and much government debt is short-term, debt facilitated spending is more palatable when rates are low than when high. The level of government spending then may be more stimulative to GDP when rates are low, with austerity gaining ground when rates are higher.

Change in the “G” component of GDP, through interest rate and consequent policy effects

If low interest rates lead to stimulative spending and much higher debt, as was the case in many economies post 2008, fear of increasing rates and higher taxes in the future may drive consumers to lower consumption, save more, and move money into tax havens if they can