How a change in Interest rates affects economy?

Controlling the interest rates affects the aggregate demand, inflation rate and the exchange rate.

Scenario one: Increasing the interest rates

An increase in the interest rates will reduce the demand for borrowing from customers and firms. If they borrow less money, they will have less money to spend and the aggregate demand will fall or rise more slowly. Moreover, individuals will be encouraged to save more due to high interest rates.

Higher interest rate will also raise the value of the country’s exchange rate as more international investors will be interested in investing their money in the country, to get better interest rates.

Scenario one: Reducing the interest rates

Reducing the interest rates will encourage people and firms to spend more money. As loans become cheaper, more people will be interested in taking loans and purchasing houses and cars. Even firms will be encouraged to expand as the cost of capital is cheap, they will find it easier to raise funds. This will fuel the aggregate demand in the economy.

How the supply of money affects the economy?

If the Government reduces the supply of money, banks and money lenders will find they have less money to lend to people and firms. This shortage of the supply of money will lead them to charge higher interest rate. Moreover, in order to obtain more money they will increase the interest rates to attract savers to put money in deposit accounts. All these actions will lead to lowering the aggregate demand and the prices will come down.

On the other hand, if the Government increases the supply of money to banks, they will lower the interest rates in order to encourage people and firms to borrow more. More individuals and firms will borrow thus boosting the aggregate demand and the output of the economy. But if the increase in supply is not calculated properly it can result in inflation.