Changes in interest rates can have different effects on consumer spending habits depending on a number of factors, including current rate levels, expected future rate changes, consumer confidence, and the overall health of the economy.
Key Takeaways
- Central banks adjust target interest rates in a country, raising them to increase the cost of borrowing when the economy is hot, and lowering them to make borrowing cheaper when the economy is sluggish.
- When interest rates go up, consumers may be more attracted to saving dollars that can earn higher interest rates rather than spend.
- When rates go down, people may no longer wish to save, but instead spend and invest, even taking out loans to consume at low interest rates.
Interest Rate Changes
Central banks adjust interest rates, either up or down, in order to combat inflation or spur economic activity when the economy slows. Interest rates affect the cost of borrowing money over time, and so lower interest rates make borrowing cheaper—allowing people to spend and invest more freely. Increasing rates, on the other hand, make borrowing more costly and can reign in spending in favor of saving.
The ultimate effect of interest rate changes primarily depends on the consensus attitude of consumers as to whether they are better off spending or saving in light of the change.
The basis behind interest rate changes as a tool for influencing the economy stems from Keynesian economic theory. The theory discusses two competing economic forces that act on consumers, and which can be influenced by interest rate levels: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS). These concepts refer to changes in how much disposable income consumers tend to spend or save.
Spend or Save?
An increase in interest rates may lead consumers to increase savings since they can receive higher rates of return. This is outlined in the marginal propensity to save. Suppose you receive a $500bonuswith your paycheck.
You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase on a new business suit and save the remaining $100, your marginal propensity to save is 0.2 ($100 change in savings divided by $500 change in income).
When interest rates are high, putting your money in a high-yield savings account will allow you to get a higher-than-average return on your savings.
The current level of rates and expectations regardingfuture rate trends are factors in deciding which way consumers lean. If, for example, rates fall from 6% to 5%and further rate declines are expected, consumers may hold off on financing major purchases until lower rates are available.
If rates are already at very low levels, however, consumers will usually be influenced to spend more to take advantage of good financing terms.
The other side of the marginal propensity to save is themarginal propensity to consume, which shows how much a change in income affects purchasing levels. If interest rates are low, people may take that $500 bonus and decide it's not worth earning next to nothing in the bank.
Moreover, they may decide to use that as a downpayment to purchase something worth $1,000, financing the additional $500 with a low-interest rate loan on a credit card, or from a bank.
What Happens to Consumer Spending When Interest Rates Are High?
Consumer spending and interest rates have an inverse relationship. When interest rates are high, consumer spending decreases. The reason is that when interest rates are high, goods and services are more expensive because the cost of borrowing is more expensive. If a consumer was looking to buy a house or a car, these are now more expensive because the interest rates on the loans needed to purchase these items are higher. Additionally, if people end up paying more for these items, they have less money to spend on other items, which also reduces overall consumer spending in the economy.
Do High Interest Rates Encourage Spending?
High interest rates encourage saving. High interest rates make goods and services more expensive due to the increased cost of borrowing through higher rates. This keeps people from spending their money, which means they are saving it. Additionally, if rates are high, consumers can receive higher returns on their savings, which further encourages saving.
Who Benefits From Higher Interest Rates?
Financial institutions, especially banks, benefit from higher interest rates. Charging interest on the loans they make is how banks make money. The higher the interest rate they can charge, the more they can make. If the interest environment is high, banks will be charging those high rates, earning more money.
The Bottom Line
The overall health of the economy impacts consumer reaction to interest rate changes. Even if rates are at attractively low levels, consumers may not be able to take advantage of financing in a depressed economy. Consumer confidence about the economy and future income prospects also affect how much consumers are willing to extend themselves in spending and financing obligations.
