Before we see how interest rates affect our purchasing decisions, we need to talk about the Messengers of Death and understand how they affect us. Yes I am referring to interest rates and inflation.
What is interest?
An interest rate is the percentage of the debt that is charged as interest. Every loan, mortgage, credit card etc. that you ever will receive will have an interest rate associated with it. These can vary wildly between financial products, and also between consumers based on their credit histories.
What is Inflation?
Inflation is a constant increase in the prices of all goods and services produced in an economy. Money loses purchasing power during inflation periods since each unit of currency buys progressively fewer goods.
Suppose the overall price index increased by 3% during the past 12 months. If a typical household spent AED 4,000.00 during the first month for all household expenses, then they must budget AED 4,120.00 during the last month for exactly the same quantity of goods and services.
In simpler terms, it can be said like
3 Liters of milk cost AED 10 earlier now costs AED 15 or you can now buy 1 Liter only for AED 10 This is often described as "too much money chasing too few goods.”
The interest rate is a monetary policy tool used to achieve price stability and sustainable growth. Changing the interest rate influences the money supply, beginning with banks and eventually trickling down to consumers.
Governments and Central Banks in particular lower interest rates in order to stimulate economic growth. Lower financing costs can encourage borrowing and investing. However, when rates are too low they can spur excessive growth and eventually inflation as has happened during the 1990s to 2006. Inflation eats away at purchasing power and could undermine the sustainability of the desired economic expansion plans set forth by countries. Meaning to say many countries draw 20 year economic targets and in order to achieve them they design and develop fiscal and monetary policies; if forecasting and subsequently economic planning had been poor, anything can go wrong: inflation, deflation, stagnation all of this in a nation.
On the other hand, when there is too much growth Central Banks raise interest rates. Rate increases are used to slow inflation and return growth to more sustainable levels.
Lower interest rates allow more people to buy and more people to purchase more expensive commodities like homes, cars etc. The negative about low interest rates is that it has a tendency to push prices of commodities higher because there are simply more buyers. It is a "supply and demand" thing.
A consumer's purchase power is seen here in the graph between QQ/SS/YY/XX the shaded area. As long as the interest rates are with the consumers'/firms' reach there is tendency to spend as it appears on QQXX but the moment RR goes above the purchase budgets B, at SSYY, the spending comes to a halt, here then, the Indifference curves and the Budget Lines re-align themselves for the consumer to adjust his optimal utility derieved from various combinations of available commodities from his newer and scarce resources.When interest rates are changed, demand can be affected in various ways.
- Income = Expenses + Saving
- Quantity of money
- Exchange rates
Income = Expenses + Saving
Against a certain level of income, for firm or a consumer an increase in interest rates will attract saving and should theoretically reduce borrowing.
This will tend to reduce current spending, by both consumers and firms; this includes spending by consumers in the shops and spending by firms on new equipment, ie investment in newer assets or expansion in to newer markets. Conversely, a reduction in interest rates will tend to increase spending by consumers and firms.
Quantity of money
A change in interest rates will affect consumers' and firms' cash flow, ie the amount of cash they have available. For savers, a rise in interest rates will increase the money received from banks and co-operative society deposits. But it will also mean higher interest payments for people and firms with loans - debtors - who are being charged variable interest rates. These include many consumers with mortgages on their homes.
Exchange rates
In practice, the exchange rate will be influenced both by expectations about future interest rates and any unexpected changes in interest rates. That is because if investors expect interest rates to rise, they may increase the amount they invest in a currency before interest rates actually rise.
"If something will cost far more than it is worth because you do not have the money to buy it, then you should wait until you can afford it and stay out of debt."
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