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Interest rates are used by central banks to stabilize the economy by limiting inflation and consumer spending. Raising interest rates can decrease consumption and inflation, while lowering them can stimulate the economy. The central bank has the power to change interest rates and affect economic growth.
The relationship between interest rates and economic growth arises from the use of interest rates as a means of achieving desired economic conditions. That is to say, interest rates are tools used to make the economy more stable by limiting unwanted factors such as inflation and rabid consumer spending. The authority that has the power to make changes to the interest rate in an economy is the central bank of the country under consideration.
Central banks use monetary policy as a means of tinkering with interest rates and economic growth. They usually do this by raising or lowering the interest rate on the money they remit to other banks in the economy. Economies have cycles which are used as a means of measuring the health of that economy and any gains that may have been made in the economy by applying different monetary and fiscal policies. When vested interests, such as economists, businessmen and businesswomen, the government and various banks observe macroeconomic and microeconomic trends after analyzing periodic economic reports, they will come to various informed conclusions about the health of the economy . Where there are unfavorable macroeconomic indicators such as rising unemployment and inflation, the central bank may decide to raise the interest rate on money transferred to banks.
This action establishes a link between interest rates and economic growth, as the purpose of raising interest rates is to address the unfavorable elements in the economy which are detrimental to economic growth. For example, the action of raising interest rates will have a knock-on effect on other banks – something that can be compared to a knee-jerk reaction. An increase in interest rates means they will tighten their lending policies and also increase the interest rate they pay on savings deposits. When consumers find that they cannot have equally easy access to different types of finance for their consumption, they will decrease the rate of that consumption.
Another link between interest rates and economic growth is how raising interest rates will save consumers money for two main reasons. The first is to conserve their money due to the perceived scarcity of such funding, and the second is to exploit the high interest rates offered by banks as a means of encouraging savings. When this happens, the activity in the economy will decrease and as a result the inflation rate will decrease. Similarly, when the central bank decreases interest rates, consumers will have easier access to finances and the consumption rate will rise, stimulating the economy.
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