Interest Rate Changes
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Interest rate changes have a significant impact on the consumption, spending, saving and investment environment, besides the foreign exchange and stock markets. Changes in interest rates are dependant on several complex factors including the economic health of a country and the inflation levels. Interest rate changes are introduced by a country’s central bank with the aim to maintain a reasonable level of economic growth.[br]
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Impact of Interest Rate Changes on Demand
Interest rate changes are a key tool of economic management and are used by the central banks of all countries to steer economic growth in the right direction. Interest rate movements have a direct impact on aggregate demand, which includes consumption, investment, government expenditure and exports and imports. An increase in interest rates raises the cost of borrowing and, thus, dampens spending by individuals and fresh investments by businesses. The high cost of borrowing makes newer projects less profitable, discouraging businesses to invest.
Interest Rate Changes and Their Impact on Bonds and Stocks
An increase in the interest rates leads to a fall in the prices of existing bonds. This is because the investors can get a better interest rate on new bonds. Similarly, interest rate changes in the downward direction lead to higher bond prices.
Rising interest rates have a negative impact on stock prices as investors tend to shift their funds in favor of bonds whose yields have risen. Investment in stocks is largely driven by optimism related to economic growth and growth in corporate earnings and increased interest rates imply that the government is trying to curb growth. Another negative impact of higher interest rates is that it raises the borrowing cost of companies and impacts their profitability.[br]
Interest Rate Changes and the Forex Markets
Interest rate changes by the central banks lead to movement and volatility in the forex market. Interest rate movements dictate the flow of investments into a country. The difference in the interest rates of various countries affects the relative worth of the various currencies in relation to one another. An increase in the interest rates of a country encourages investors to invest in its currency and boosts its demand. Similarly, a fall in the interest rates dissuades investors from purchasing assets and the weak demand for the currency results in its depreciation.
