A:

Changes in interest rates can have different effects on consumer spending habits depending on a number of factors, including current rate levels, expected future rate changes, consumer confidence and the overall health of the economy.

It's possible for interest rate changes, either up or down, to have the effect of increasing consumer spending or decreasing spending and increasing saving. The ultimate determinant of the overall effect of interest rate changes primarily depends on the consensus attitude of consumers as to whether they are better off spending or saving in light of the change.

Keynesian economic theory refers to two conflicting economic forces that can be influenced by interest rate changes: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).These concepts basically refer to changes in how much disposable income consumers tend to spend or save.

Spend or Save?

An increase in interest rates may lead consumers to increase savings, since they can receive higher rates of return. An decrease in interest rates is often accompanied by a corresponding increase in inflation, so consumers may be influenced to spend less if they believe the purchasing power of their dollars will be eroded by inflation.

The current level of rates and expectations regarding future rate trends are factors in deciding which way consumers lean. If, for example, rates fall from 6% to 5% and further rate declines are expected, consumers may hold off on financing major purchases until lower rates are available. If rates are already at very low levels, however, consumers will usually be influenced to spend more to take advantage of good financing terms.

The overall health of the economy impacts consumer reaction to interest rate changes. Even with rates at attractively low levels, consumers may not be able to take advantage of financing in a depressed economy. Consumer confidence about the economy and future income prospects also affect how much consumers are willing to extend themselves in spending and in financing obligations.

(For related reading, see: What is the relationship between inflation and interest rates?)

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