The new inflation rate came out this morning, and it’s dropped slightly compared to last month. This reminded me of a common mistake that many people make when they hear interest rates are rising; it’s actually an indication that the economy is too strong. So I thought I’d see if I can manage to do what my A’ level economics teacher never quite managed with me – make interest rate moves understandable; of course to do so I’ve made it very, very basic, but hopefully it’ll help.
Increase Interest Rates
• Saving is incentivised. As interest rates are higher, you’re more likely to save money. Saving money takes cash out of the economy as it’s no longer being spent.
• Borrowing is discouraged. As interest rates are higher, borrowing is more expensive, so you’re less likely to borrow (including borrowing for a mortgage). When you borrow it means you’ve more money to spend, adding fuel to the economy, so less borrowing means less money is added to the economy.
This is why increasing interest rates is done to slow down the economy, as it means less cash is circulating.
Decrease Interest Rates
• Saving is discouraged. As interest rates are lower, you’re less likely to save money. This means you’re more likely to spend cash, helping fuel the economy.
• Borrowing is encouraged. As interest rates are lower, borrowing is cheaper, so you’re more likely to do it. When you borrow money, the likelihood is you’ll spend it, again adding fuel to the economy.
This is why interest rate cuts are used to try and stimulate the economy.
Hope this helps, if you’re new to all this, you may also like the How Interest Rates Work article
