Effect of Interest Rates on Savers and Economy

December 9th, 2007 | interest-rates -

Readers Question: What is the effect for increased interest rate on country and depositors

I have answered this question a few times before:

I don’t want to repeat what I have already written so will just make a few ‘new’ observations.

Higher interest rates increase the cost of borrowing and make it more attractive to save. This is likely to reduce consumption and reduce the rate of economic growth.

However, there is also an income effect of higher interest rates. As interest rates increase, savers (people who have deposits) will see an increase in interest rate payments. – Basically, saving has a higher reward. Therefore, savers see an increase in disposable income this could actually cause an increase in consumption.

However, in the UK, the savings ratio is very low. The UK has high levels of personal debt. Therefore an increase in interest rates will reduce the disposable income of people with mortgages and debt. This will outweigh the increased incomes from depositors. In the UK, higher interest rates have a particularly big effect in reducing consumer spending because of the size of mortgages.

Generally, interest rates are used to control inflation. Higher rates are used to reduce inflationary pressures. The UK economy is particularly sensitive to interest rate changes.

Higher interest rates also make it more attractive to save money in the UK, as opposed to other countries. Therefore, higher rates will cause ‘hot money flows’ and may cause the value of the £ to rise.