Do people save more when interest rates are high?

Changes in interest rates can have different effects on consumer spending habits depending on a number of factors, including current rate levels, expected future rate changes, consumer confidence, and the overall health of the economy.

Key Takeaways

• Central banks adjust target interest rates in a country, raising them to increase the cost of borrowing when the economy is hot, and lowering them to make borrowing cheaper when the economy is sluggish.
• When interest rates go up, consumers may be more attracted to saving dollars that can earn higher interest rates rather than spend.
• When rates go down, people may no longer wish to save, but instead spend and invest, even taking out loans to consume at low interest rates.

Interest Rate Changes

Central banks adjust interest rates, either up or down,in order to combat inflation or spur economic activity when the economy slows. Interest rates affect the cost of borrowing money over time, and so lower interest rates make borrowing cheaper - allowing people to spend and invest more freely. Increasing rates, on the other hand makes borrowing more costly and can reign in spending in favor of saving.

The ultimate effect of interest rate changes primarily depends on the consensus attitude of consumers as to whether they are better off spending or saving in light of the change.

The basis behind interest rate changes as a tool for influencing the economy stems from Keynesian economic theory refers to two competing economic forces that act on consumers, and which can be influenced by interest rate levels: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS). These concepts refer to changes in how much disposable income consumers tend to spend or save.

Spend or Save?

An increase in interest rates may lead consumers to increase savings since they can receive higher rates of return. This is outlined in the marginal propensity to save. Suppose you receive a $500 bonus with your paycheck. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase on a new business suit and save the remaining $100, your marginal propensity to save is 0.2 ($100 change in saving divided by $500 change in income).

The current level of rates and expectations regarding future rate trends are factors in deciding which way consumers lean. If, for example, rates fall from 6% to 5% and further rate declines are expected, consumers may hold off on financing major purchases until lower rates are available. If rates are already at very low levels, however, consumers will usually be influenced to spend more to take advantage of good financing terms.

The other side of marginal propensity to save is marginal propensity to consume, which shows how much a change in income affects purchasing levels. If interest rates are low, people may take that $500 bonus and decide its not worth earning next to nothing in the bank. Moreover, they may decide to use that as a downpayment to purchase something worth $1,000, financing the additional $500 with a low-interest rate loan on a credit card, or from a bank.

The Bottom Line

The overall health of the economy impacts consumer reaction to interest rate changes. Even with rates at attractively low levels, consumers may not be able to take advantage of financing in a depressed economy. Consumer confidence about the economy and future income prospects also affect how much consumers are willing to extend themselves in spending and financing obligations.

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.

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.

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 of 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.

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