By now, we are no stranger as to how higher interest rates can cause a surge in US dollar, how it is going to increase the cost of borrowing, property prices and how it can affect our savings. (Read more on 5 Reasons Why An Interest Rate Hike Can Affect You). By affecting so many components in the aggregate demand equation, it’s inevitable that it will affect economic growth which is highly dependent on aggregate demand. (Read more on How Interest Rates Would Affect Economic Growth) In fact, higher interest rates can not only affect economic growth, but also the unemployment rate which is another important factor used to measure the economic health of any economy.
We’ve learnt the three different types of unemployment (demand-deficient, structural and frictional unemployment) in our previous article and in case you wonder which type of unemployment interest rates affects, let’s break it down for your understanding.
The term itself is quite obvious that higher interest rates would affect demand-deficient unemployment. Obvious because structural unemployment exist when there is a mismatch of skills between the relevancy of what the firm wants and how adequately skilled the worker is. Frictional unemployment is inevitable when there is imperfect information between both firms and workers such that they need time to be aware of the type of labour available out there and the types of jobs availability.
Demand-deficient unemployment aka cyclical unemployment occurs due to a deficiency in aggregate demand. A rise in interest rates is likely to decrease consumer expenditure as it makes more sense to save. Assuming wages remains the same, as borrowing costs increase, a greater part of disposable income is likely to be channeled into repaying any existing interest payments as compared to purchasing goods and services.
Similarly for investments, higher costs of borrowing would translate into lower profits which may affect the company’s decision for further investments. Coupled with a fall in aggregate demand for goods and services, lesser production is needed and therefore, much less lesser workers are required.
Since higher interest rates is going to cause the US dollar to appreciate, a higher US dollar is going to cause its exports to be less competitive. Overall net exports decline because imported goods and services become cheaper. More become imported while less is demanded domestically. With a greater fall in aggregate demand for goods and services, again, lesser production is needed and even lesser workers are required.
To increase economic growth or to decrease unemployment, the central bank can increase the money supply in the economy. When that happens, the amount of reserves in the banking system would increase, and in turn pushing interest rates lower. Lower interest rates decrease the incentive to save, as well as the cost of borrowing. An increase in consumer expenditure and investment expenditure would cause aggregate demand to rise and in turn, increasing overall national output. An increase in demand for goods and services will lead to a rise in demand for labour which results in a decrease in unemployment.