Interest rates have broad effects throughout the economy.
The level of base interest rates in the United States has a significant effect on the supply and demand of goods and services produced in the nation's economy. Among the areas of the economy that interest rates affect are consumer spending, business expansion and contraction, the rate of unemployment, the rate of inflation, and the behavior of the financial markets.
Consumer Spending
It goes without saying that the less you can pay for a big-ticket item, the better. New purchases of costlier products like an automobile or an investment in a home improvement project such as a remodeled kitchen can put a hefty dent into a family budget. During times of rising interest rates, many consumers will ease up on discretionary spending -- that is, optional purchases of things we do not necessarily need, like that big-screen high-definition television for the family room. Conversely, when interest rates have fallen or remain steady at low levels, consumers opt to make those discretionary purchases more often.
Inflation
More borrowing that results in more spending can in turn lead to inflation if spending increases beyond a certain difficult-to-predict point. During times of lower interest rates, when consumer spending increases to such a level that it affects the supply of goods and services available, the prices of those goods and services may increase substantially. When the dollar buys less, it can result in inflation, an indirect result of lower interest rates. The Federal Reserve may intervene and raise interest rates to slow inflation.
Stocks and Bonds
Investors attempt to follow the best deals. Interest rates guide the behavior of some investors as the level of interest rates affects the stock market, commodity prices and especially the bond markets. Bond prices correspond negatively to interest rates. Generally, when interest rates rise, bond prices decrease, and when interest rates decline, bond prices increase. The reason for this effect is that when bonds are sold, the current interest rate at the time of the sale as well as projections of what the interest rate will be at the time of the bond's maturity are factored into the cost. Lower interest rates may also spur an increase in investments in stocks.
Businesses and Employment
The interest rate level produces similar effects on the business world as it does on consumers. Low interest rates may induce businesses to invest and can lead to new projects, expansion and job growth, resulting in lower rates of unemployment and higher rates of economic growth. Higher interest rates have the opposite effect on businesses, as owners and managers tighten their belts. If the price of money, i.e., interest rates, becomes too exorbitant, businesses may contract to the point where jobs are eliminated or work hours reduced.
