Write an account of the causes and effects of an increase in the Rate of Interest

1. Introduction

    The rate of interest is the price of capital. If money is deposited in a bank or building society the depositor is rewarded with a payment of interest. The interest rate is referred to as the reward for surrendering liquidity.
    An investor who wishes to expand their business will probably ask the bank for a loan. If the loan is granted it will have a price tag. The bank will charge a rate of interest since it is surrendering capital to the entrepreneur.
2. Causes of an Increase in the Rate of Interest
A number of factors cause the rate of interest to increase, as below. 3. Effects of an Increase in Interest Rates

Positive Effects

  • Savings are encouraged because of greater returns on deposits
  • Borrowing is discouraged having a deflationary effect
  • Reduced borrowing leads to a reduction in imports
  • There will be an inflow of funds from abroad
  • Negative Effects
  • Investment is discouraged because of the increase increased price of borrowing
  • Aggregate demand will fall because of the decline in investment
  • The reduction in aggregate demand could lead to an increase in unemployment
  • Home owners will have to pay higher charges on their loans