How Does Interest Rate Affect the Economy?

Interest Rates

It is known that changes in the interest rates can have both its advantages and disadvantages on the economy. A ripple effect regularly happens when the Federal Reserve Board (Fed) alters the rate upon which banks borrow money from each other.

In this article we will examine how these interest rates affect the whole economy, stock and bond markets, as well as inflation and recessions.

Interest Rates Affect Spending

For every loan, there is a higher probability that the borrower would not return the money. Thus, the interest comes into the picture. It is the amount of money that lenders receive after sending out a loan and the borrower pays back.  In simple terms, the interest rate is the whole loan percentage that is being charged to the borrower by the lender.

Consequently, if the interest rate is lower, there are more people becoming willing to borrow money as they decide on to make purchases like cars or houses. If a borrower pays a lesser interest, they are given enough money to spend, hence creating a ripple effect to the economy.

Even both farmers and business owners benefit when the interest rates are low. It prompts them to purchase large equipment since the cost of borrowing is low. It then affects the output and productivity of the before-mentioned industries.

On the contrary, if the interest rates are high, consumers tend to cut back their spending. Banks also make fewer loans and this affects the whole economy from the consumers to businesses. It can also mean businesses cutting down the number of employees they have.

Interest Rates Affect Inflation and Recessions

The rise and fall of interest rates also affect the federal funds rate or the rate in which banks use to charge each other for loans being made. Federal funds rate affects other existing loan rates and the changes can have an effect on inflation and recessions.

The Fed raises the federal funds rate to manage the rising prices. If there are higher interest rates, the borrowing costs could be increased and in turn, people tend to spend less. Further, the demand for goods and services will also decrease and then leads to a fall in inflation.

On the other note, decrease in interest rates lead to ending recessions. If the Fed lowers the federal funds rate, then borrowing of money turns out to be cheaper and it can entice people to begin spending all over again.

In totality, by the raising and lowering of the federal funds rate, the Fed is given the capability to prevent hyperinflation and lessen the gravity of recessions.

Interest Rates Affect U.S. Stock and Bond Markets

Usually, federal funds rate help investors determine how they are going to invest their money, since both certificate of deposits and treasury bonds are being affected by it. The rise on interest rates, businesses and consumers reduce their spending which in turn causes the falling of earnings and dropping of stock prices. On the contrary, the reduction of interest rates will result to consumers and businesses augment their spending, consequently, stock prices increase.

Additionally, bond prices also get affected by interest rates. The relationship is an inverse one – meaning, when there is an increase in interest rates, bond prices decrease and when there is a decrease in interest rates, bond prices increase.


By keeping an eye on the federal funds rate, the Fed gains control over the economy to keep it in balance. Knowing the relationship between interest rates and its effect on the economy will give any market enthusiast to see the big picture and further make better decisions when doing investments.


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