Interest rate is the percent charged on a loan or paid on savings; interest rate can be change by a government and central banks. The main reason for the governments and banks to change the interest rates is to control inflation. Inflation must be controlled as it an economic disaster for a country as the prices reach new levels. Inflation has a heavy cost: it creates instability and a transfer of money from lenders to borrowers. The whole objective of raising interest rates – although the consequences are disastrous – is to decrease the inflation level.

Rising interest rates affects all of the following economic variables: consumption, investment, growth, unemployment, imports and exports, savings and mortgage payments. Thus interest rates have quite a significant effect on the economy. Interest rates only have a real direct effect on two of these variables, consumption and currency. The other variables are of course affected as well but also because of the change of one or more variables added to the rise in interest rates. The level of consumption is the consumer’s expenditure or in other words, the purchase and use of goods and services by consumers, or the quantity of these purchased. The level of consumption will decrease for simple and obvious reasons: if interest rates are raised the banks will charge more for their loans and credits. This reaction from the banks will send a disincentive to the borrowers; a borrower will have to pay more interests for a loan therefore there will be less borrowers. But it is the borrowers that need the money in order to consume and they will not be able to do so anymore. Rising interest rates also have another effect which is to increase the value of the currency. This is because if one country will raise its interest rates than foreign speculators will move their money to benefit from the rise of interest rate, this means that they will sell for example pounds to buy Euros. There will be a higher demand for Euros which means that the value of the Euros will increase. However that is only if the real interest rate is positive. The difference between real interest rate and nominal interest rate is that real interest rate takes into account inflation. Nominal interest rate is just a monetary value; real interest rate is the difference between that value and the rate of inflation. If the real interest rate is positive it means that the inflation rate will be less than the nominal interest rate.

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An increase in the value of the currency has less impact on other variables than a decrease of the level of consumption. A decrease in this has a direct effect on investment. Investment is the use of money for future profit (buying stock in a company to make benefit), or an amount of money invested in something in the purpose to make profit.  As we know, in order for companies to invest they will have to take a loan however, the banks have put their interest rates up. This sends the same disincentive to the investors as it did to ...

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