1.6.3 - Interest rates and spending
Interest rates influence the cost of borrowing and the reward for saving. This lesson explains how a rate change can affect business finance, consumer spending and sales, and why its impact differs between firms and customers.
Borrowing costs and saving rewards
The interest rate connects a borrower's financing cost with a saver's return.
Interest rate
The percentage charged on borrowed money, or paid on savings, over a stated period.
A business borrowing to buy equipment normally pays interest in addition to repaying the amount borrowed. A higher applicable rate increases the interest cost of that borrowing. A project must then generate more benefit to justify financing it; a business may postpone buying a machine or opening another branch. Lower rates can make borrowing cheaper, but a cheap loan still has to be repaid and the proposed investment still needs customers.
A business with money saved may receive more interest when the applicable savings rate rises. This is a benefit to the saver, whereas the borrower faces a cost. A firm with both deposits and debts must consider the combined effect and their different rates and amounts; a general rise is not automatically good or bad for every firm.
Existing borrowing arrangements matter. A variable rate can change during the borrowing period, so the interest cost may respond to a rate change. A fixed rate remains as agreed during the fixed period; a wider rate rise need not immediately change that loan's interest payments. New borrowing or refinancing may still be affected. The rates offered to particular businesses also depend on the lender and perceived repayment risk.
These are illustrative mechanisms rather than current interest-rate figures. Rate decisions and the institutions responsible for them differ between economies.
Consumer borrowing and spending
A change in interest rates can alter both the money consumers have available and their willingness to spend it.
Customers buying costly items such as cars or household appliances may use credit. Higher applicable rates increase the cost of financing the purchase, making it less attractive; customers may delay replacing an otherwise usable appliance. Customers with existing variable-rate loans may also pay more interest, leaving less income for other purchases. A furniture retailer can therefore lose sales without borrowing any money itself.
Higher savings rates can encourage people to save rather than spend now. However, a person with substantial savings may receive extra interest income and spend some of it. This is why “every customer spends less” is an unsafe claim. Customers with fixed-rate debts or no debts may face less immediate pressure than those whose borrowing cost changes.
Lower rates can reverse these pressures: new consumer credit may become cheaper, variable-rate interest payments may fall, and saving may become less rewarding. This can encourage spending and increase businesses' demand. The result is conditional. Customers worried about their jobs may still avoid borrowing, and lenders may refuse credit. A rate cut does not force a household to purchase.
Demand for optional, expensive or credit-financed purchases often responds more than demand for essentials. A car dealer and a food retailer may therefore experience different sales changes after the same rate rise. Assess the customers and purchases involved, not only the direction of the rate.
Direct and indirect business effects
A business can be affected directly through its own finance and indirectly through changes in customer demand.
In an illustrative business scenario, an appliance manufacturer has variable-rate borrowing, and many customers finance new washing machines with credit. A rate rise may increase its interest expense while reducing demand for its products. With fewer sales, revenue may fall; higher financing costs then put further pressure on profit and the cash available to meet bills. The two routes reinforce one another, but they are distinct.
Contrast an illustrative local food shop with no borrowing and customers who mainly pay from current income. Its direct borrowing cost cannot rise if it has no loans. Customers might still have less money after paying interest on their own debts, but they need food, so the sales effect may be smaller. An illustrative business with substantial savings may gain deposit income even while customer demand weakens.
An owner deciding whether to invest should compare the project's expected returns with the finance cost and likely demand. An investor considering buying shares may compare the uncertain return from shares with available savings returns; a higher deposit rate can make saving more attractive, although risk and expected business growth also matter. Neither owners nor investors can infer a firm's complete performance from a rate change alone.
A business response could include delaying a credit-funded expansion, keeping a cash reserve or offering a lower-priced product. The best response depends on its objectives, debts, savings and customers. Rate effects may take time as existing contracts expire and customers revise their plans.