Interest rates can be defined as the cost of borrowed funds; it can also be defined as the opportunity cost of borrowed resources. Interest rates are used by policy makers to implement monetary policies that involve adjusting interest rate levels. When interest rates are adjusted they will affect the level of borrowed funds. Interest rates will therefore affect the consumption behaviour and at the same case affect the investment behaviour in the economy.
Interest rates will determine the amount of money supply in an economy, and because the higher the money supply then the higher the inflationary pressure interest rates are used as a way to fight inflation in an economy. This paper discusses the effects of a change in the level of interest rate of investment and on consumption.
Investment behaviour and interest rates:
Investment can be defined as accumulation over time by firms of real capital goods and these goods yield the future flow and acquisition of other goods, investment levels in an economy will be determined by the interest rates which are the opportunity costs of borrowed funds, this is because most investments involves the borrowing of funds and therefore an increase in interest rates will discourage investment while a decline in interest rates will encourage investment.
According to Keynes the investment level was a function of interest rates and this relationship portrayed by Keynes is described in the diagram below:
When interest are at IR1 which are higher than IR2 then the level of investment is I1 which is at a lower level then I2, however when the interest rates are lower and the level is at IR2 then the level of investment increases to I2. This diagram shows the relationship between investment and interest and an increase in interest rates therefore will discourage investment while a decline in investment will increase investment efforts.
Neoclassical theory states that an increase in the interest rates will reduce investment; they state that an increase in interest rate will result into an increase in the cost of capital and as a result of this increase in cost then investment will be reduced. For this reason therefore according to classical economists the interest rates will affect the investment levels in the economy, when there is an increase in the interest rates then the lower will be the rate of investment while a reduction in the interest rates then there will be an increase in investment.
When investment increases it will result to demand push inflation which originates from the real sector, when investment increases then the aggregate demand will increase and this will result into inflation. However when the investment levels increase then we expect the level of employment and income in the economy to increase, this will be beneficial to the economy where the rate of employment will increase and the output level of the economy will also increase in terms of GDP.
According to Keynes theory on the demand for money he highlighted that individuals will demand money for speculative purposes, precautionary purposes and liquidity preferences. Speculative demand for money occurs where the individuals will prefer to hold money as an asset when other assets do look attractive, The level of speculative demand for money will depend on the interest rates and the income levels, when interest rates are high then the speculative demand for money is lower and when the interest rates are lower then the
individuals will hold more speculative money demand, for this reason therefore individuals will hold more money and will not invest when the interest rates are high but when the interest rates are low the individuals will hold less speculative money and they will invest in other assets.
Consumption behaviour and interest rates:
According to Keynes consumption constitutes the largest proportion of expenditure in an economy, however in his theory he defined consumption as a function of income, consumption therefore was equal to the autonomous consumption level plus the marginal propensity to consume which is multiplied by the income minus tax.
Consumption will be affected by changes in the level of interest rates, when interest rates are high then the demand for borrowed fund will decline and therefore the less the ability by consumers to spend, when interest rates are low then the demand for borrowed funds increase and for this reason the higher the ability by consumers to spend.
When the money supply in an economy is high then the higher is the demand by consumers because they will have more disposable income to spend, as a result of this therefore a decline in the interest rates will increase money supply in an economy and as a result there will be an increase in spending by consumers, as a result the aggregate demand of an economy will increase.
A rise in interest rates will therefore result into a decline in the consumer demand for goods and services and a decline in the interest rates will result into an increase in the consumers demand for goods and services, this change is as a result of the increase or decrease in the money supply in an economy.
Demand for good and services is increased by the increase in money supply, when more loans are available to consumers at affordable interest rates then the demand for these loans increases and as a result there will be increased consumption.
The effect of interest rates on consumption can also be viewed in terms of investment, when the cost of borrowed funds becomes high as a result of an increase in interest rate then the cost of goods and services in an economy is also high, when the price is high then the less the demand, therefore if there is a decrease in the interest rate levels the cost of investment is low and so is the cost of producing goods. Low prices of goods and services will increase demand for goods and services as the law of demand depict and therefore the consumption level in the economy will increase.
The increase in money supply as a result of a reduction in the interest rate will have inflationary pressure on the economy, for this reason therefore we expect the price of goods in the economy to increase, the inflationary pressure is caused by the high aggregate demand which is higher then the aggregate supply, the rise in price will be as a result to demand push inflation. Demand push inflation can be caused by the real sector and the monetary sector, the demand push inflation caused originate from the monetary sector.
Lowering of interest rates will result into increased in investment, when investment increases then it is likely that the amount of goods and services produced in the economy will be diverse and consumers will have a larger choice of goods, as a result the consumers will increase spending and therefore consumption levels in the entire economy will increase.
Also when investment increases we expect that the employment level in the economy will increase and therefore the per capita income eve will increase, as a result therefore the consumers will have a higher disposable income and therefore there will be an increase in the consumption level.
On the other hand if we considered Keynes theory of income we can also conclude that when interest rates increase then the level of consumption decreases, according to Keynes income
(Y) is equal to consumption (C) plus investment (I) plus government, if we consider that savings is equal to investment then savings will depend on the rate of interest. For this reason therefore when there is an increase in the level of interest rates there is an increase in the marginal propensity to save and more consumers will prefer to save than spend and for this reason more funds will be allocated to savings and less to consumption and therefore consumption levels will be lower.
From the above discussion it is clear that an increase in the level of interest rates will decrease the consumption level and also the investment level, also that a decline in the interest rates will result into increased consumption and also increased investment.
When interest rates are high demand for borrowed fund declines because more people cannot get loans at affordable rates, and when interest rates are low the demand for borrowed funds increase due to the affordable rates available, for this reason therefore when interest rates are low individuals will have more disposable incomes and therefore consumption will increase.
Investment will also depend on the level of interest rates, when interest rates are high then the level of investment is low and when the interest rates are low then the level of investment is high. Interest rates therefore will be used as a policy tool that aids the policy makers achieve desired economic growth.
The decline or increase in interest will not only affect the consumption levels and investment, interest rates will also affect the inflation levels in an economy, for this reason therefore when changing the rates of inflation the policy makers have to consider the adverse effects of a change in interest rates on the economy.
B. Snow (1997) Macroeconomics: Introduction to Macroeconomics, Rout ledge publishers, London
Stratton (1999) Economics: A New Introduction, Pluto Press, New York
Philip Hardwick (2004) Introduction to Modern Economics, Pearson Press, New York
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