Interest Rates and Their Effect on Saving, Borrowing and Spending

One change, two directions

An interest rate is the price of borrowing money, and it is also the reward for lending it. Those are the same thing seen from two ends, which is why one piece of news is read in opposite directions by different people at the same moment. When rates rise, somebody with savings is better off, because their money now earns more. Somebody with a loan is worse off, because their borrowing now costs more. Nothing about them changed. Only the rate did. Hold on to that reversal, because it is the answer to most questions in this part of the course. Your specification looks at two groups. Consumers make decisions about saving, borrowing and spending. Producers, meaning firms, make decisions about saving, borrowing and investment. Notice that the last word is different, and keep it different: consumers spend, firms invest. A firm weighing up whether to buy new equipment is doing the borrower's calculation on a larger scale, and it will reach a different answer when borrowing is dearer. You will also learn what pushes the general level of rates up and down, and how to work out the interest earned on savings.

Words for money that moves

Six terms used precisely in this topic. The first two are worth reading together, because a rate is a cost and a reward at once.

Who gains when rates rise

Interest rates rise. Two people hear the news: one has money in a savings account, the other is repaying a loan. Who is better off?

• The saver, because the reward for saving has risen, while the borrower now faces a higher cost
• The borrower, because a higher rate means the loan is repaid sooner
• Both, since a rise means there is more money in the economy
• Neither, because interest rates only affect firms

Households and firms, side by side

What a RISE in interest rates tends to do to each group's decisions. Read across the rows: the logic is the same, but the last decision has a different name for each group.

Match each decision to what a rise does

What pushes rates up or down

Your specification asks what influences the level of interest rates, so here are the influences. Inflation. When prices are rising quickly, money repaid in the future buys less than money lent today, so lenders want a higher rate to make lending worthwhile. Higher inflation therefore tends to push rates up. How much borrowing is wanted compared with how much saving is available. Interest is a price, and like other prices it responds to the balance between the two sides. If many people and firms want to borrow while relatively little is being saved, the price of borrowing tends to rise; if there is plenty being saved and little demand for it, it tends to fall. Risk. A lender who thinks repayment is less certain will charge more, which is why different borrowers are offered different rates at the same time. The length of the loan. Lending for longer means waiting longer to be repaid and carrying uncertainty for longer, which usually means a higher rate. Competition between lenders. Where lenders compete for savers or borrowers, rates move to attract them. Notice that this explains what MOVES rates, which is what you are asked for here. Who sets rates in an economy, and how that is used as policy, is a separate part of the course.

Which two influence the level

Select the TWO things that influence the general level of interest rates.

• The rate of inflation, since money repaid later buys less when prices are rising quickly
• How much borrowing is wanted compared with how much saving is available
• The amount a household chooses to spend on food each week
• The number of firms in an industry producing a particular good

Work out the interest earned

Someone saves £400 for one year at an interest rate of 5% a year. How much interest do they earn over the year? Give the amount in pounds, as a number only.

The effect in a sentence

An interest rate is the _____ of borrowing and the reward for _____. When rates rise, borrowing becomes more _____, so consumers tend to reduce their _____ and firms tend to reduce their _____. The original amount saved or borrowed, before interest, is called the principal.

A firm decides whether to invest

Here is how a rate change reaches a firm, using the cost and revenue ideas you already have. A firm is thinking about buying a machine. It expects the machine to add a certain amount to its revenue each year, and it would pay for the machine by borrowing. The decision is a comparison: does what the machine is expected to add exceed what the borrowing will cost? Suppose the borrowing would cost the firm £250 in interest over the year at a rate of 4%, and the firm expects the machine to add more than that to its revenue. The project is worth doing. Now interest rates rise. The same borrowing costs more, but the machine still adds the same amount. Some projects that just about paid for themselves no longer do. The firm does not necessarily cancel everything: it drops the projects nearest the line, and keeps the ones with the largest expected return. That is why economists say investment tends to FALL when rates rise, rather than saying it stops. Notice two things. First, nothing about the machine changed; only the cost of the money did. Second, this is the same reversal you met with the saver and the borrower, applied to a firm. The consumer with a loan has less left to spend; the firm with a loan has less reason to invest.

The answer with the direction reversed

Four sentences from answers about a RISE in interest rates. Select the ONE that gets the direction wrong.

• Saving becomes more attractive, because savers now earn a greater reward on the money they hold.
• Consumer spending tends to fall, particularly on items usually bought on credit.
• Firms are more likely to invest, because borrowing to fund the investment has become cheaper.
• A household already repaying a loan has less income left over to spend on other things.

Say both sides at once

Assemble a sentence that states the reversal properly.

Rates have gone up

Interest rates have risen. Three people ask what it means for them. Work through each.

• Someone has money in a savings account and no debts. What has changed for them?
• Someone is repaying a loan and was planning a large purchase on credit. What would you expect?
• A firm was about to borrow to buy equipment. What is the likely effect?
• You are asked what the rise means for the economy overall. What is the best answer?

Explain how interest rates change decisions

Explain what an interest rate is, what influences its level, and how a rise affects the decisions of both consumers and producers.

• Define an interest rate as both the cost of borrowing and the reward for saving
• Name at least two influences on the level of interest rates and explain each
• Explain what a rise does to a consumer's saving, borrowing and spending
• Explain what a rise does to a firm's saving, borrowing and investment
• Use the words spending and investment correctly for each group
• Explain why investment tends to fall rather than stop
• Finish by explaining why the same change makes savers better off and borrowers worse off