Since modern finance became a thing, Central Banks have had a vital role in determining the market’s overall direction. One of the essential tools that Central Banks have at their disposal is the base interest rates. This is the interest rate that, when adjusted, can increase or reduce the money supply in the economy.
For decades, there has been a clearly defined inverse relationship between the base interest rate and stock markets. Whenever Central banks raise interest rates, stock markets drop, and the inverse holds. With such power bestowed upon the Central Banks, it is only natural to wonder, how can interest rate affect a country’s economy.
Interest rates have both a positive and negative effect on the economy short term. However, in the long run, they are designed to help stabilize the economy and keep it moving for the good of all citizens. To help you better understand interest rate, here are a few ways interest rates affect a country’s economy.
They spur foreign direct investment
When a country’s Central Bank raises interest rates, it tends to increase the value of a country’s currency. That’s because the supply shrinks relative to demand. The higher interest rates also mean that investors can earn more by buying the said country’s bonds. The result is that the country gets an influx of foreign investments that can help rejuvenate the economy and drive growth.
They help regulate inflation
Inflation is expected in an economy and actually helps drive up asset prices over time. However, when it gets to a point where the money supply exceeds its absorption in the economy, then costs for essential commodities begin to rise, and that hurts consumers. Central Banks handle this situation by raising interest rates when the money supply starts outpacing its absorption in the economy.
For instance, after the 2008 global financial crisis, Central Banks such as the Federal Reserve lowered interest rates to zero or close by. This helped shore up liquidity in the economy and led to a recovery and the record-beating asset prices experienced at the equity markets’ peak in 2021. However, as of 2022, it is clear that the money supply has surpassed its absorption in assets and other uses, hence the rising inflation. For this reason, Central Banks have raised interest rates to control inflation and get the economy going again.
This is an ever-ongoing cycle that has helped keep inflation manageable for decades and will continue for years to come.
Interest rates can help regulate borrowing in the economy
One of the critical factors that help keep the economy going is debt. While there are a lot of connotations around debt, it is one of the key factors behind the massive growth of wealth in modern times. For instance, since interest rates dropped to zero after the 2008 financial crisis; there has been unprecedented growth in wealth across the globe. That’s because it is easy for both individuals and corporations to borrow for speculative investing and production.
That said, debt is not always prudently used, and as of 2022; there is a debt crisis, not just at the personal level but also at the sovereign level. Central Banks use interest rates to regulate the level of debt in the economy; and to keep borrowing at healthy levels for long-term sustainable growth.
Interest rates are an integral part of keeping the economy functioning. They are among the most important monetary policy tools Central Banks have at their disposal to keep the economy functional at any time. Interest rate help keep inflation at acceptable levels; drive foreign investments in the economy, and keep debt levels in the economy at acceptable levels.