- How do higher interest rates affect economic growth - Free Economics Essays How do higher interest rates affect economic growth

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How do higher interest rates affect economic growth

Higher interest rates affect economic growth in several ways. It is important to note that interest rates fall into the category of monetary policy, that is policy that is set by the central bank. It is the primary policy tool that the central bank (e.g. the Bank of England or Federal Reserve) have of driving changes in the economy. Interest rates are the cost of borrowing for businesses and individuals and also their return on saving.If interests rates rise, typically we see several results. Firstly, the cost of borrowing increases so firms face a higher cost of borrowing and borrow less. This typically results in reduced capital expenditure (investment in their businesses) and an increased level of saving of excess cash within their business. Secondly, and similarly, individuals save more and spend less. They delay purchases that rely on debt, e.g. buying a new house or car and choose to deposit their money and gain interest on their savings. These actions typically also result in a strengthening of the currency relative to peers as deposits from overseas flow into the country as foreign savers seek the increased returns provided. This has a direct effect on the trade balance of the country as its exchange rate strengthens and its exports become more expensive and the cost of importing falls.The overall consequence is a net reduction in aggregate demand and a resulting reduction in inflationary pressures as demand within the economy slows down.

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