How Interest Rates Affect Economic Growth?

There are four main factors which are often used to measure the economic health of any economy; economic growth, unemployment, inflation and the balance of payments. An economy with high economic growth, low unemployment, low inflation and a balance of payment equilibrium is usually considered well performing. Conversely, an economy with low economic growth, high unemployment, high inflation and a balance of payment disequilibrium is usually considered poor performing.

Of course, the aim of any government is to achieve a well performing economy with high economic growth, low unemployment, low inflation and a balance of payment equilibrium.

Since we understood the relationship between interest rates and exchange rates, let’s dive further into how powerful interest rates can affect all one of the four main factors: ECONOMIC GROWTH

The size of an economy is measured by the amount of final goods and services produced, hence the economy grows when the amount of final goods and services increases. Economic growth is seen as an increase in real national income or real national output instead of nominal national income or nominal national output. Reason being, nominal income is national output measured at current prices. This means that an increase in nominal income could be due to an increase in current prices instead of an increase in the amount of goods and services produced.

Real national income, however, is measured at base-year prices. This means that any increase in real national income can only be reflected by an increase in the amount of goods and services produced as base prices do not change.

 

Actual economic growth essentially means an increase in actual output. An increase in aggregate demand would lead to an increase in actual output (or economic growth). However, the rise or fall in aggregate demand is determined by many other factors such as consumer sentiment, household income, interest rates, expectations of price changes, availability of credit and the distribution of income etc. The effect of a rise in interest rates last month is likely to decrease consumer expenditure because it makes more sense to save more when interest rates are high! As borrowing costs become more expensive, the availability of credit is likely to fall and a greater part of disposable income is going to be used for repaying any existing interest payments. (Read more on 5 Reasons Why an Interest Rate Hike Can Affect You)

Investment expenditure is also determined by several factors such as interest rates, business sentiment, business costs, capital costs, corporate income tax, technological advancements and the availability of costs. Similarly, a rise in interest rates will increase the cost of borrowing where there would be less profitable investments, causing a decrease in investment expenditure.

Government expenditure on goods and services is largely dependent on the objective of the government. They can either choose to increase government expenditure or decrease taxes or both. U.S. President Donald Trump has promised to lower tax, starting with corporate taxes and then moving on to personal taxes. However, this has brought about a huge debate that the Republicans’ proposed tax cuts would create a $2tn revenue shortfall over the next 10 years. Together with a proposal of $54bn increase in defense spending against the ISIS, deficit gaps are only going to get wider while public debts spikes further. Funds can only be obtained by increasing interest rates, and this would affect interest-sensitive spending such as consumer and investment expenditure as mentioned above.

An increase in interest rates is also going to cause a surge in the US dollar as capital is likely to shift back to the economy. A higher US dollar is only going to make exports less competitive which would affect the overall aggregate demand in the economy. With lesser demand for goods and services comes lesser supply, and lesser workers needed to produce these goods and services. Unemployment becomes inevitable when overall net exports decline.

 

Since the size of an economy is measured by the amount of final goods and services produced, lesser consumer and investment expenditure coupled with a fall in net exports is likely to cause an overall decrease in actual output produced. Since an increase in output may spur inflation, a decrease in output may also bring about deflation in the long run. (Read more on 5 Reasons Why Deflation Spells Bad News for Any Economy.) Unless increasing government expenditure and cutting taxes could neutralize or overpower the negative effects interest rate hike is going to have, actual output might have a chance of increasing. It is always about finding the balance in between. Otherwise, both have its own risks of increasing the amount of debt U.S. is going to undertake. Whether it is feasible in the long run remains another story to be told.

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