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Definition: The interest rate effect is changes experienced in macroeconomic indicators caused by an alteration in the interest rates. It can also refer to the modification in the interest rate originated by a change in the overall price level.

What Does the Interest Rate Effect Mean?

This term is applied differently depending on the context or the situation where it is referred to but the definition that is most commonly employed refers to the alteration suffered by interest rates due to changes in an economy’s price level.

There’s a direct relationship between price levels and interest rates, the highest the price level, the highest the interest rate. In addition, a raise in interest rates causes a decrease in overall expenditures, since many manufacturing companies and financial institutions tend to reduce their investments when interest rates are high and consumption decreases since it is more expense to buy through credit. Also, interest rates affect savings.

The higher the interest rate, the higher the amount saved by households, under normal circumstances. The housing market is also affected by the interest rate effect, since most homes are bought trough mortgages and borrowers tend to postpone the purchase of a house in a high interest rate environment. From an economic standpoint, the interest rate effect, derived from price level changes, has the ability to shape many elements of the macroeconomic environment.

Example

Let’s take this as a hypothetical example. In Norway, the inflation rate has been increasing non-stop since 2008. It has grown from an annual rate of 1% to 15% last year. This has caused interest rates to increase to an all-time-high of 25%.

Capital expenditures have decreased 12% since companies are less willing to invest in new machinery and equipment, because of the elevated financial expenses that come along with it. Housing prices have also experienced a considerable reduction, because the interest rate environment is considered hostile by most home buyers.

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