In modern economies, some individuals earn more money than they need to spend on present goods. There are other individuals who have a desire for more money than they can presently access. A natural market arises between those who have a surplus of present funds (savers) and those who have a deficit of present funds (borrowers). Savers, investors, and lenders are only willing to part with money today because they are promised more money in the future—it's the interest rate that determines how much more.
Key Takeaways
- Interest rates can determine how much money lenders and investors are willing to save and invest.
- Increased demand for loanable funds pushes interest rates up, while an increased supply of loanable funds pushes rates lower.
- Central banks, such as the Federal Reserve, manipulate interest rates to influence monetary policy.
- When interest rates are high, the cost of borrowing is higher, which results in people spending less. When interest rates are low, the opposite is true.
Supply and Demand for Loanable Funds
The interest rate describes how much borrowers need to pay for loans and the reward that lenders receive on their savings. Like any other market, the market for money is coordinated through supply and demand. When the relative demand for loanable funds increases, the interest rate goes up. When the relative supply of loanable funds increases, the interest rate declines.
The demand for loanable funds is downward-sloping and its supply is upward-sloping. The natural rate of interest in an economy balances out this supply and demand. This mechanism sends a signal to savers about how valuable their money could be. Similarly, it informs possible borrowers about how valuable their present use of the borrowed money needs to be to justify the expense.
The natural rate of interest is mostly a theoretical construct in contemporary economies. Central banks, such as the Federal Reserve, manipulate interest rates to influence monetary policy. For example, a central bank can make it cheaper to borrow and less valuable to save by lowering interest rates in the economy. These actions change the intertemporal incentives faced by economic actors.
4.6%
The U.S. personal saving rate as of May 2023.
Capital Structure and the Economy
Suppose an entrepreneur wants to start a new manufacturing company. The entrepreneur cannot start generating sales until the factors of production, such as factories and machines, are in place and operational. This production framework is sometimes referred to as the business capital structure.
Most entrepreneurs don't have enough money saved up to purchase or build factories and machines. They usually have to borrow the startup money. It can be easier to borrow money if the interest rate is low as it costs less to pay back. If the interest rate is so high that the entrepreneur isn't convinced that they can earn enough to pay it back, the business may never get off the ground.
This is how the interest rate helps determine the overall capital structure of the economy. There have to be enough savings for all of the houses, factories, machines, and other capital equipment. Additionally, the subsequent capital structure has to be profitable enough to pay back the lenders. When this coordinating process malfunctions, asset bubbles can form and whole sectors can be compromised.
Liquidity Preference vs. Time Preference
Economists disagree about the exact nature of interest rates. Interest rates have to coordinate past and future consumption, and they place a premium on risk and the safety of liquidity. This is essentially the difference between liquidity preference and time preference.
How Do Interest Rates Influence Spending?
Interest rates influence spending by making spending more or less expensive depending on the direction of interest rate movements. For example, if interest rates go up, the cost of borrowing goes up, meaning it is more expensive to buy goods, so consumer spending decreases. When interest rates fall, the cost of borrowing comes down, so it is cheaper to buy goods, so spending increases.
Do High Interest Rates Cause Saving?
High interest rates can cause an increase in savings. Because high interest rates increase the cost of borrowing, making goods more costly, individuals spend less, and thereby, save more. In addition, the return on high-interest savings accounts increases, making it more appealing for customers to deposit their money in these accounts and earn a high interest on their money.
How Does Inflation Affect Savings?
Inflation reduces the value of savings. As inflation is the increase in the price of goods across an economy, the amount of money in a person's savings account is worth less, meaning the money can't buy the same amount of goods as it could before, so its value is reduced.
The Bottom Line
Interest rates are a key component of any economy with a far-reaching impact. The level of interest rates impacts how much people save and spend. Generally, when interest rates are high, people will spend less and save more, as the cost of borrowing money to buy items such as houses and cars increases, whereas the return on savings deposits is higher. When interest rates are low, the opposite is true. The central banks of countries control interest rates either to spur the economy or slow it down.
