Why Interests Increase and Decrease! What's the Effect?

Posted on Tuesday 12th of August 2014 by Chelsea Leigh

Everything in the business world has a cycle of increasing and decreasing. Interest rates aren’t any different; they are constantly fluctuating, increasing and decreasing. Interest rates follow the trend of the economy; if the economy is strong then the interest rates will be high. If it is struggling then the interest rates will be low.

When the Global Financial Crisis (GFC) hit most global economies were hit hard and have slowly been recovering since. Interest rates after the GFC were incredibly low. This is because the financial standings of most people had become very weak, people and businesses were less willing to borrow or spend money. The banks therefore needed to entice new borrowers; they did this through decreasing interest rates.

Richard Barrington from Money Rates gave some authoritative words regarding the low interest rates after the GFC.

‘The economy is the reason interest rates are so low right now’. He continues, ‘When the economy is weak, people and businesses are less inclined to borrow money. Like anything else, the cost of loans is affected by supply and demand, and low demand for loans means that the cost of loans – the interest rates- has to come down’.

When the interest rates are high this is generally due to the economy being strong. If the economy is strong then banks have an understanding that people and businesses are in a more comfortable financial position, where they are willing to borrow money with a higher interest rate.

Another influence in the fluctuation of interest rates is that Reserve Bank of Australia (RBA) use interest rates as a tool to help regulate, stabilise and control the economy and economic growth. They either trying to ‘slow’ or ‘quicken’ economic growth. By altering interest rates the RBA indirectly puts more or less money in people’s pockets to either increase or reduce spending in the economy. This results in changing inflation, the gross domestic product (GDP) and the unemployment rate.

The Commonwealth bank made the statement in an article they posted that, ‘Reserve banks generally decide to cut interest rates when they want to increase investment and spending by individuals and businesses, this helps lift pace of growth.’

They also stated that ‘A rise in interest rates could be aimed at putting the brakes on economic growth or inflation’.

As discussed, interest rates change according to the economy; depending on whether it is strong or weak. They change to counteract the speed of economic growth. It is all dependent on the economy but generally occurs in a cycle. Just like the saying ‘What goes up must come down’.

By discussing why interest rates increase and decrease we now have a basic understanding and can delve into a couple of different areas of the economy that interest rates directly affect.

Change to Inflation

Google defines inflation as the ‘general increase in prices and fall in the purchasing values of money’.

Interest rates can directly affect inflation, and the Banks are known to increase or decrease the interest rates to either decrease or increase inflation. If the interest rate is reduced it is likely that the inflation rate will rise because both people and businesses are able to borrow money and therefore are willing to spend more. The demand will eventually start to overtake the supply and this will cause prices to increase.

On the other hand if inflation starts to increase too rapidly then the RBA can do the opposite to slow inflation down. They will do this by increasing interest rates, and therefore people will be encouraged to save rather than spend. Thus the supply will begin to overtake the demand and prices will soon drop.

Buying and Selling Businesses

The buying and selling of businesses is one specific market that is directly affected by the changes in interest rates. This is because to buy a business it is most likely you will need finance from a bank to help finance the purchase of a business.

If the interest rates are high, then many cannot afford or are less inclined to get finance for the business, therefore there are less people purchasing businesses. This like the inflation affects the supply and demand equation, supply increasing and demand decreasing, therefore causing over time the prices of businesses to decrease as well.

If the interest rates were low then people would be more willing to invest in the businesses as low interest rates entice borrowers. This would increase demand and therefore the prices of businesses for sale would increase due to the competition between buyers.

The market fluctuates between a ‘Buyers’ market or a ‘Sellers’ market, what this means is that it is distinguishing who has the power in the market at the present and this can directly correlate to whether the interest rates are high or low. If it is a buyers’ market this would mean that the interest rates are high. For the few buyers who are still financially able to finance or buy businesses they are in control over the pricing to a certain extent as sellers would be eager to come out on top for the lowest price to entice those buyers to buy ‘their’ business.

For the sellers’ market it is the opposite, interest rates would be low. Therefore more competition between the buyers, and the buyers would be constantly trying to outbid each other in order to snatch up that business with the available option of the low interest finance.

Interest rates fluctuate according to the economic standing and the Reserve bank. Reserve Banks can use interest rates to try to control the speed of the economy’s growth, either to speed or slow down the rate of growth. Overall if the economy is strong you will find that interest rates will be high, if the economy is low then interest rates will be low. It is the cycle of the economy, again ‘What goes up must come down’. Good Luck.