How Interest Rates Affect Investments, Businesses, and the Economy

Introduction

Do you know that interest rates set by the central bank plays a major role in deciding the profitability of your investments, your businesses and also your job perhaps? 

In any economy, several key participants drive economic activity, including Households, Businesses, Government, Financial Institutions, the Foreign Sector, the Labor Market (Workers), Policymakers, Investors, and Consumers.

Much like how the human body relies on various organs to function and maintain survival, these economic participants are essential for sustaining economic growth, stability, and ensuring that people lead prosperous lives.

However, there’s one crucial factor that ties all these participants together: the flow of money. Interest rates serve as the main tool to regulate this flow. 

Just as maintaining healthy blood pressure is vital for the body - ensuring it’s neither too high nor too low, interest rates play a critical role in keeping the economy's "circulatory system" running smoothly. 

Proper interest rates encourage investment, foster savings, and maintain a balance that drives overall economic activity.

What are interest rates?

Interest rate can be defined as the cost of borrowing or the percentage charged for a loan amount from the perspective of the borrower. 

From a savers point of view, interest rate is the rate of return that savers receive on their savings accounts. 

So, for borrowers, Interest rate is a cost. While for savers, interest rate is a reward.

Who sets the interest rate in a country?

The Central bank of a nation, also known as the bank of banks, is responsible for setting key interest rates, such as the policy rate or benchmark rate. These rates influence borrowing and lending behaviors across the entire financial system. 

Why are Interest rates Important?

The primary goal of setting interest rates is to manage inflation. Inflation occurs when there is too much money in circulation chasing too few goods, causing a rise in the overall prices of goods and services.

Most central banks use a 2% target inflation rate. To achieve this, they use interest rates to regulate the flow of money within the system. When inflation rises above 2%, this indicates a strong demand for goods and services that suppliers cannot meet. Therefore, suppliers respond to this demand by raising prices.

This causes inflation to rise above 2%, and if this increase is severe, central banks normally respond by raising interest rates. Raising interest rates takes money out of circulation. How? When interest rates are high, they attract people to save money in banks. 

Since less money will be chasing goods, this tactic helps to lower and maintain prices for goods and services, keeping the inflation rate at the target rate of 2%. Therefore, when interest rates are high, commercial banks effectively pull money out of the economy as more people save money for higher returns, helping to lower overall prices of goods and services.

When prices are too low or when inflation is falling below 2%, this indicates weaker demand, which could lead to deflation, meaning prices are too low. While this is initially beneficial for consumers, deflation is harmful to businesses of all types and sizes. This condition can eventually lead an economy into a recession.

To deal with deflation or to stop an economy moving into a recession, central banks usually lower interest rates. This makes borrowing more cheaper, as a result the overall demand for goods and services in an economy increases, this promotes businesses growth, employment etc. 

However, the results are not immediate. For any economy to respond to changes in interest rates, and for inflation to adjust to these changes, it typically takes an average of six months.

The main job of any central bank is to maintain an optimal level of interest rates, ensuring there isn’t too much or too little money circulating in the economy. It’s similar to blood pressure in the human body, both need to be at the right level. Too high or too low, and the consequences can be harmful.

Here is the interesting part. Interest rates are so important because they determine how fast or slow the flow of money happens among all the key economic players such as firms, government, workers, investors, consumers etc. within an economy. 

This in turn determines new job openings, new businesses and the expansion of existing business, new foreign investors, consumer spending, housing market, stock market activity, crypto market, profitability of businesses and finally your economic wellbeing!

💡Quik Tip: Before diving deeper, it’s essential to understand a fundamental truth: Money was never created to be idle. It was designed to flow from person to person, from country to country, so that everyone can benefit. That's why a good flow of money within an economy is very important.

Let's now look at how interest rates affect the key players in an economy.

Impact of Interest Rates on Consumers

For consumers, the rate of interest can largely affect their financial decisions. For example, when the interest rate is high, it encourages us to save more expecting a higher return. 

Many people will tend to cut off their spending as much as they can and save their money in the banks to earn more money. This reduces overall demand or what we call as aggregate demand within an economy.

Aggregate demand can be defined as the total demand for all finished goods and services within an economy.

When the rate of interest is low, we are usually more inclined to take out loans and spend more. Why? Because the cost of borrowing is cheap. 

Further, low interest rates also discourage us from saving money in the banks, therefore we are more likely to use that money for spending or put that money in other profitable alternative investments. Thereby, increasing aggregate demand for goods and services.

Summary

Higher interest rates ➡️ Decreases Aggregate Demand ➡️ Leads to a drop in sales ➡️ Production of goods and services declines ➡️ jobs lay off takes place as a response ➡️ Unemployment level rises. 

Lower Interest rates ➡️ Boosts Aggregate Demand ➡️ Sales rises ➡️Production of goods and services grows ➡️ more job vacancies open to meet the increased demand ➡️ employment level rises. 

Impact of Interest Rates on Businesses

Interest rates can affect Businesses of all types and sizes in regard to profitability. Higher interest rates would put businesses into unfavorable situations when it comes to repaying existing loans as the cost of repayments rises reducing profitability. Businesses tackle these cost increments mostly by laying off staff. 

For example, tech companies like Amazon, IBM, Spotify, Facebook and Wall Street banks including Goldman Sach laid off thousands of employees in 2023 to deal with rising interest rates costs.

Higher interest rates also discourage businesses from taking out loans to support operations and expansions. This negatively impacts the companies' outlook, leading to a decline in their share prices.

What about export businesses? Higher interest rates usually strengthen the US dollar or the local currency. For example, when the FED decides to raise interest rates, this attracts foreign investors to buy dollar denominated assets like US bonds, causing the US dollar to appreciate in value compared to other currencies.

Higher interest rates therefore make U.S. exports more expensive for other nations, as they must spend more of their local currency to purchase the same amount of dollars. This price increase reduces demand for U.S. export products as buyers turn to cheaper alternatives from other countries, impacting the profitability of export businesses in the U.S.

Since rate hikes discourage consumer spending, demand for goods and services drops, leading to reduced business profitability and slower growth.

On the other hand, lower interest rates have the opposite effect. They encourage consumer spending, and businesses, facing increased demand, are more likely to take out loans due to the low cost of borrowing. This allows them to expand, hire more workers, and meet the rise in total demand.

Lower interest rates also positively impact export businesses. The dollar will depreciate against other currencies as low rates discourage foreign investments, exports will become cheaper as a result.

Summary

Higher interest rates ➡️ Increases cost of loan repayments ➡️ businesses cut costs by laying off workers.

Higher interest rates ➡️ Discourage consumer spending ➡️ reduce total demand for goods and services ➡️ businesses revenues and profits drops ➡️ businesses cut costs by laying off workers.

Higher interest rates ➡️ Strengthens the US dollar in forex market ➡️ Makes exports expensive ➡️ sales decline for export businesses.

Higher interest rates ➡️ Cut profits ➡️ negatively affect the image of companies ➡️ share prices drop.

Lower Interest rates ➡️ Encourage consumer spending ➡️ business take out more loans cheaply to expand its operations ➡️ employ more workers. 

Lower Interest rates ➡️ facilitate businesses expansions ➡️ increases business profits ➡️ improves its public image ➡️ share prices rise.

Lower Interest rates ➡️ Weakens the US dollar ➡️ Makes exports cheaper ➡️ Increases international demand ➡️Export business thrives.

Impact of Interest Rates on Investors

Interest rates affect the risks and returns associated with various investments made by investors; therefore, interest rates play a crucial role in shaping the decisions made by investors.

Higher interest rates usually mean business will experience a decline in its sales and therefore revenue and profits, additionally, the cost of expansion for businesses also increases affecting future profits.

Investors see these things as risks causing them to pull back from certain investments, particularly in sectors like real estate and tech.

As a result, Stock prices tumble. For example, In December 2024, Jerome Powell cut interest rates by 0.25%. However, the Fed's cautious approach, signaling just two more rate cuts in 2025, created a negative market sentiment for investors. This led to a sharp sell-off in tech stocks, wiping out nearly $1 trillion from the U.S. stock market, with the Nasdaq dropping 4.9%.

Conversely, lower interest rates make borrowing cheaper, encouraging businesses to take loans for expansion and investment. This can boost their growth prospects, making stocks in those businesses more attractive to investors.

When interest rates rise, safer investments like government bonds become more attractive, this encourages investors to shift from riskier investments like stocks and crypto to these safer investments for higher returns leading to a decrease in crypto and stock prices.

When prices of riskier investments fall, this creates panic among other investors, as a result they also withdraw their money causing a further fall in asset prices. 

Conversely when interest rates fall, the returns on bonds decrease, making riskier investments more appealing.

Summary

Higher Interest Rates ➡️ Borrowing becomes expensive, slowing economic activity ➡️ Businesses earn less, making stocks less appealing ➡️ Bonds offer better returns, attracting investors ➡️ Money shifts from stocks to bonds ➡️ Stock prices drop as demand for risky investments decreases.

Lower Interest Rates ➡️ Borrowing becomes cheaper, encouraging spending and investment ➡️ Businesses grow, boosting confidence in stocks ➡️ Bonds offer low returns, pushing investors toward higher-risk options like stocks ➡️ Stock prices rise as more money flows into the market and businesses perform better.

Impact of Interest Rates on Housing Markets 

Interest rates play a big role in the housing market, and we’ve all seen how they can make or break it. When interest rates are low, it feels like everyone is rushing to buy houses because borrowing money is cheaper. 

Mortgage payments are more affordable, and people feel confident they can invest in property. This drives up house prices because there’s more demand.

But when interest rates go up, things start to change. Higher rates mean bigger monthly mortgage payments. Suddenly, people think twice before buying a house, and those already paying mortgages might struggle to keep up. This causes demand for houses to drop, and with less demand, prices can stall or even fall.

For example, in 2022-2023, some housing markets around the world slowed down when central banks raised rates to fight inflation. People couldn’t afford to borrow as much, and housing demand cooled off, causing price drops in places like Canada, New Zealand, and parts of Europe.

So, as we can see, interest rates are like the throttle for the housing market. When rates are low, the market speeds up; when rates rise, it slows down, and sometimes it crashes. It’s something we all feel, whether we’re buying, selling, or just watching the news.

Impact of Interest Rates on Bond Markets 

Governments issue bonds for various reasons. But one major reason is to pull money out from the economy to cool inflation. 

To achieve this, the government issues bonds for financial institutions like banks, other institutional investors like pension funds, mutual funds and insurance companies and foreign investors.

When interest rates hikes, newly issued bonds usually come with higher coupon rates (yields) making bonds more attractive and a safer investment. As a result, demand for new bonds increases as investors seek a higher return on newly issued bonds.

What about the old bonds? when demand for new bonds climbs, the demand for old bonds in the secondary market declines. This causes prices of existing bonds to fall. When prices of existing bonds fall, these bonds also become attractive to investors to buy at their current yields.

The main purpose of raising interest rates by a central bank is to slow down an economy. From the perspective of investors this is bad news, because when an economy slows down, business activities slow down, shrinking revenues and profits. Therefore, investors won't invest in riskier assets like stocks and Crypto. 

Impact of Interest Rates on Crypto and Stock Markets 

When interest rates are low, borrowing becomes affordable for both consumers and businesses, businesses take out loans for expansions and operations, this leads to increase in jobs.

When people get more jobs, people have money in their hands as a result they spend their money and invest the extra cash they make increasing economic activity which is in turn is both good for businesses and people.

Mortgage payments become affordable for homeowners leaving them with extra money to meet their wants, investors become more inclined to invest in riskier assets because low interest rates signal a positive environment for businesses and economy overall.

What about the exchange rate then? low interest rates cause US dollar to weaken in value against other currencies as foreign investors shift their investments from US banks to other international banks for higher interest rates. 

A weaker dollar is a very positive for international retail investors. Why? because they need less of their currency to buy dollars to invest in dollar denominated assets like Crypto and stocks. 

All these things are considered as a green light for Stocks and Crypto. Low interest rates make investors greedier for crypto due to very positive market sentiment, we can see this crypto fear and greed index. 

Conversely when interest rates are high, the market for stocks and crypto turns red. 

How interest rates affect globally

When the FED in the US makes announcements about its interest rates, the whole world listens. Why? because the dollar plays an important role as the global reserve currency for many nations. 

When the FED announces a cut in interest rates, it is positive news for countries that have borrowed money in dollars. These countries now face lower repayment costs, as the amount they need to pay back each month decreases. 

Conversely, when the FED raises interest rates, it is negative news for these countries, as the cost of repayments increases. Additionally, the value of the dollar typically appreciates, making it even more expensive for these countries to repay their debts, both directly and indirectly.

When the FED announces to raise interest rates, this negatively affects the stock markets and equity markets in other nations as many foreign investors move their capital into the US banks and institutions to benefit from higher returns. This is known as Capital flight. 

However the opposite could also happen. The US dollar being the reserve currency for many nations does not mean that all countries are less powerful than the US. All countries are interconnected to each other in everything, including global trade in unimaginable ways. 

For example, when Japan raised interest rates after 15 years in 2024, investors who had bought stocks in the U.S. stock market by converting Japanese yen into dollars began to panic. Why? Because when Japan hikes interest rates, it is inevitable that the yen will appreciate in value against the dollar.

This situation is related to the carry trade, a strategy where investors borrow money at low interest rates from one country and invest it in another country's assets or financial institutions for a higher return.

As the yen appreciates, investors who had borrowed money from Japanese banks now find themselves in a difficult position. Since the yen has strengthened, these investors must now pay more in dollars to cover their debts tied to their U.S. investments. 

The result was a significant sell off in the US stock market as well as in the cryptocurrency market. 

Final Thoughts

Interest rates are a crucial factor that determines your wealth. If you didn’t know this, well, now you do, consider yourself lucky! When interest rates are low, riskier investments thrive, and the markets are green and bullish.

If you want to get out of the rat race, learn about investments and start investing wisely. 

Dollar cost averaging during high-interest rate periods can be a smart strategy because, during these times, prices of both stocks and crypto underperform and can be bought at a massive discount. But remember, prices won’t recover quickly, they will eventually bounce back when rate cuts are announced.

If you’re planning to open a business with a loan, apply when interest rates are low. Banks are more likely to approve loans during these periods, especially if your creditworthiness is strong. This is because governments often buy back bonds from commercial banks, pumping liquidity into the banking system and making funds more accessible.

“Interest rates are like a huge ocean wave. If you want to prosper financially, dive with it, not against it”.

Disclaimer: The contents of this article are for informational purposes only and are not financial advice. The views here are just the author’s opinions. The crypto market is volatile, so be sure to do your own research before investing.