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.