How Do Changes in Interest Rates Affect Economic Growth?

Interest rates have economic impact as both an indicator and influential element in the growth of the market. The interest rates on large purchase items such as homes, small business loans and automobiles can show if the economy is healthy or if it is slowing down and needs an influx of cash to get going again.

Low Interest Rates

In a poor economy, banks and other financial institutions tend to lower interest rates on loans to entice businesses to apply for credit. This allows money to circulate through the economy and stimulate growth. The process creates a symbiotic cycle where businesses use the loan money to acquire new property and build new locations that filters down to consumers and private construction companies, who are then hired to build new business properties and operate the new locations. Consumers use the money received from working to purchase goods and services at other existing businesses.

High Interest Rates

Rising interest rates are a strong indicator of economic growth, according to the "U.S. News" website. As economic development increases, more businesses reach out to banks and other financial lenders for extensions of capital. Banks see this as an opportunity to turn a profit and slowly begin increasing interest rates. This must be done carefully, as interest rates that are deemed too high may lead to inflation. This economic condition is caused by an increase in the price of goods along with a shortage in available capital.

Consumer Spending

Interest rates also affect consumer confidence in the economy, which directly affects consumer spending. When the economy is experiencing a downturn, consumer confidence may be low, causing people to save more and spend less. Low interest rates may entice consumers to spend more on large ticket items, such as cars and houses, but only if the job market is secure. Consumers who are unsure if they can keep a position long term in a poor economy are less likely to take advantage of low interest rates.

The Risk of Deflation

Interest rates that dip too low can lead to an economic condition known as deflation. This is an increase in available capital along with decrease in the price of goods. While this sounds like a good thing on the surface, it's actually quite harmful for businesses who now have to sell a higher number of goods to turn the same amount of profit. This can lead to a shrinking economy where the value of goods and property, including homes and other real property, decreases across the board.