Shouldn’t it work in the reverse? If businesses are getting loans at higher interest rates shouldn’t they be doubling down on investments as a safety net?
In: 3
Relative rates of return.
If interest rates go up to say 4% – people can safely make a return on their cash ahead of inflation.
While they’re close to zero – if you want a return you need to buy equities/bonds which will likely give a higher return.
So raising interest rates, in theory reduces the amount invested in the economy as people save more.
No, your interest rate is the cost of your loan. Let’s consider money to be a commodity. For X amount of money the cost is Y. If it becomes 2Y, then you are actually able to afford less amount of X.
If you have only $10 and the price of bananas went from $5 to $10, then previously you were able to afford 2 bananas and now you can only afford one.
[deleted]
They won’t. It’s a scare tactic used by the money men to manipulate you to vote for people who will give them tax cuts.
Say you have 2 investment opportunities (similar risk) – one returns 6%, the other 10%. If the borrowing cost (interest rate) is 5%, then you could do both and still profit. If the borrowing cost is now 7%, then it would make no sense to borrow to invest in a 6% return.
The other effect is the competition for money. If someone could invest in a risky business or asset that earns 10% whereas lending money (risk free) is earning 1%, more people would choose the risky asset/business. If lending money earns 5%, then more people would choose to lend money rather than invest in risky assets.
Rising interest rates results in fewer investments in the short term. Lenders will want lower risks or higher returns before they are willing to lend. Borrowers will not want to undertake projects that have low returns.
There are two big issues at play here – one is that businesses constantly borrow money, and lots of it. Two is the purchasing power/utility of money.
When interest rates go up, it is expected that banks and businesses will borrow less, because the cost of money goes up. Less borrowing typically means less growth, less investment, or some kind of reduction in operations of the business. Regarding the purchasing power/utility of money. Interest is a cost, and the more a business has to pay for that loan, the less capital they have for other things. Businesses may hold back on spending overall if they have a need to continue to borrow the same amount of money at a higher interest rate. They only have so much to spend, and that means less money changing hands – the economy only does well when money is moving, a recession is caused by the lack of movement of money. So the “movers and shakers” in the market will bail out of their most lucrative or speculative investments, and the prices of securities drop the more they sell. It actually becomes a self fulfilling prophecy.
I think it is hard concept for some people to consider, but consider this – money is a resource like any other resource that has to be bought. Fungible resource, yes but still a resource. Money costs money. Banks sell money, How do we buy money from a bank? With more money. But you might only have so much, and like when the price of anything else goes up, if we want to buy it the extra cost has to come from somewhere.
Businesses borrow money to fund growth (buy property, build factories, carry inventory) so if that becomes more expensive, then it costs businesses more to operate. They aren’t typically buying stocks, bonds, etc. as part of their business (some may, but if they’re not an investment bank or insurance company, etc. those aren’t operating revenue anyway).
It won’t necessarily cause markets to crash. However, raising interest rates does a few things. It slows down the general economy because there’s fewer loans taking place, so there’s less demand for commodities. It also makes bonds a better investment, so investors will prefer to sell stocks and buy bonds instead. However, this only applies to bonds issued *after* the rate increase, bonds issued before the rate increase still have the older, lower interest rates so they’ll also get sold along with stocks as investors need access to more money to buy the newer, higher interest rate bonds. In addition, many companies borrow a lot of money and pay that debt by borrowing more money. This gets them more cash on hand to fund growth. Increasing interest rates will make it more expensive for those companies to do so, cutting into their ability to grow, which is one of the things that investors look for when they invest in a company. If growth slows, then investors are more likely to sell their stocks in that company to buy new bonds instead.
Latest Answers