Central banks have played a significant role in defining the general direction of the market since since modern finance became a thing. The base interest rates are one of the most important tools available to central banks. This interest rate can be changed to either increase or decrease the amount of money in the economy.
The base interest rate and stock markets have had a well-established inverse relationship for many years. Stock markets decline whenever central banks increase interest rates, and the opposite is also true. With the Central Banks granted such authority, it is only logical to ask how the interest rate can impact a nation’s economy.
On the short term, interest rates have an impact on the economy that is both beneficial and negative. However, in the long run, they are intended to support economic growth and stability for the benefit of all citizens. Here are a few ways interest rates impact a nation’s economy to help you comprehend them better.
They spur foreign direct investment
The value of a country’s currency typically rises when the central bank of that country boosts interest rates. The reason for this is a decline in supply compared to demand. By purchasing the aforementioned nation’s bonds, investors can increase their profits due to the higher interest rates. As a result, the nation experiences a surge in foreign investments that may help revive the economy and spur growth.
They help regulate inflation
Inflation is normal in an economy and, over time, actually helps raise asset prices. The problem for consumers arises when the money supply surpasses the economy’s capacity to absorb it. At that point, prices for necessities start to rise. When the money supply begins to exceed its consumption in the economy, central banks respond by increasing interest rates.
For instance, central banks like the Federal Reserve cut interest rates to zero or very close to it following the global financial crisis of 2008. As a result, the economy’s liquidity was bolstered, the economy recovered, and record-breaking asset prices were seen at the height of the equity markets in 2021. However, it is evident as of 2022 that the money supply has outpaced its consumption in assets and other purposes, which is why inflation is on the rise. Because of this, Central Banks have increased interest rates in an effort to curb inflation and revive the economy.
This continuing cycle has contributed to keeping inflation under control for many years and will do so for many more.
Interest rates can help regulate borrowing in the economy
Debt is one of the vital components that keeps the economy humming. Despite the negative connotations associated with it, debt is a major contributor to the current era’s rapid increase in wealth. For instance, wealth has increased globally at a never-before-seen rate since interest rates were lowered to zero following the financial crisis of 2008. That’s because borrowing money for speculative investing and production is simple for both private citizens and businesses.
However, debt is not always utilised responsibly, and as of 2022, both the personal and national levels of government are experiencing a financial crisis. Interest rates are regulated by central banks in order to maintain healthy levels of borrowing for long-term sustainable growth.
Interest rates play a crucial role in maintaining the health of the economy. They are some of the most crucial tools for monetary policy that central banks can use at any time to keep the economy running. Interest rates encourage foreign investment, keep debt levels in the economy at manageable levels, and assist keep inflation at manageable levels.
