How does the interest rate regulation effect the demand and supply of credit in the country?

Answer 1

demand and supplyInterest rate regulation refers to the cost of credit. If the interset rate rises, than this means that the amount of expenditure in the economy will fall. This is due to the fact that as interest rates rise, the cost of borrowing credit goes up, this then invokes house holds and firms to stop investing because they will be paying more interest. Thus the 2 sectors (households and Firms) start saving. This means that there is less private investment expenditure in the economy, therefore bringing along with it less money in the economy invested into capital. This means there will be less job opportunities in the economy, hence unemployment can rise, and therefore income will fall... therefore there will not be much spending, and this means demand for goods and services will fall, which decrease the amount of demand in the economy, and increases the amount of supply!!!

Edit: The above answer is fairly misleading in my opinion. The statement that interest rate is the price of credit is correct. This means that we can consider saving as "credit supply" and borrowing as the "credit demand". If interest rates were allowed to self regulate then, through the price mechanism, interest rates would provide information to borrowers and investors and supply and demand would vary as required according to changing economic conditions. In this hypothetical situation price (interest rate) acts as a mechanism that guides the allocation of resources (in this case credit) as required by the economy.

In reality though the government fixes the interest rate. This is a form of price fixing and as such it conveys misleading information to buyers (borrowers) and sellers (investors). Setting artificially low interest rates encourages borrowing and discourages saving, thus setting up a misallocation of resources and encouraging risky economic behaviour, e.g. expanding speculative projects at a time when doing so is not favourable. In addition it rapidly exhausts the supply of real credit and so encourages borrowing and inflation.

Setting artificially high interest rates has the opposite effect- borrowers find it difficult to obtain credit while saving and investing is artificially stimulated. In this case business expansion is discouraged when it is required by the prevailing economic conditions.