Question

Everything in the economy is intricately intertwined. Can you think of other examples of how an increase in interest rates may affect your household?

Answer 1

Everything in the economy is intricately intertwined.

Every change in an aspect of the economy has a change in the other aspects too,thus all functions of the economy seem to be intricately intertwined.The monetary policy and fiscal policy are tools used by the Fed to bring about changes in the nations economic activity.Fiscal policy consists of the taxation policy and spending of the government.Monetary policy is concerned with regulating the total supply of money in the economy by bringing changes in the interest rates.

When the Fed increases the interest rates,it comes with a purpose.and it thus affects every aspects of the economy.Thus increase in interest rates affects the households in various ways.

Adjustments in the interest rates,have an impact on the households interest payments,as well as their disposable income.This is referred to as the monetary policy's cashflow channel.

Higher interest rates affect households through substitution and income effect.Through the substitution effect high interest lowers consumption for a certain household as consumption in the current situation,is expensive as compared to saving,thus they save more.

On the other hand through the income effect,there is a boost in consumption from certain households who receive more income from increased rate of interest.

For example,when the FED,increases interest rates a household who does not earn from interest will save more and spend less,in such situations the household will concentrate their spending on basics and will put off any expenditure like holidays on a stay till there is a fall in interest rates and they have more disposable income.

An increase in interest rates,divert the flow of the income of the household towards higher loan payments and less general spending.

Also a borrowing may be postponed by households till interest rates fall in the future.

However for households earning from interests they will increase their spending as there is an increase in their disposable income.So increased interest rates affects different households differently.