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Interest Rates

How do interest rates affect consumption?

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October 05, 2010 4:42PM

Real interest rates influence the level of household consumption in a country. Consumption of durable goods is interest sensitive, since households will sometimes finance the purchase of "big ticket items" such as automobiles, household appliances, computers, televisions, and other goods through borrowing. Households will respond to higher real interest rates by decreasing their consumption of these non-essential items since it becomes more costly to borrow when interest rates rise.

Real interest rates are determined by taking the nominal interest rate, which is the actual percentage charged by banks for a loan, and subtracting the rate of inflation. For instance, a nominal interest rate of 5% in a situation where unanticipated inflation is 2% equates to a real interest rate of 3%. Households consider the real rate of interest when deciding to purchase durable goods requiring financing.

If inflation is anticipated, banks will charge higher nominal interest rates to borrowers and therefore anticipated inflation has little or no effect on the real interest rate and consumption. Nominal interest rates rise with anticipated inflation as banks must charge higher rates to maintain their profits, since inflation erodes the value of money and a borrower would be paying back money worth less than the money he borrowed if nominal rates were not increased. However, if there is unanticipated inflation, or inflation greater than the rate anticipated by banks and incorporated into the rate charged to borrowers, then this will reduce the real interest rate and induce households to spend on durable goods, since the opportunity cost of holding money (the inflation rate) increases while the opportunity cost of spending money (the nominal interest rate) remains the same.

During periods of unanticipated inflation, the real interest rate falls and households are more likely to consume more at every level of disposable income. If there is unanticipated deflation (a decrease in the price level), then the real interest rate rises, and since households would now have to pay back their lending banks with money worth more than that borrowed, the incentive is to save more and decrease consumption. A rise in real interest rates caused by a decrease in the price level results in less consumption at each level of disposable income.