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?)

RELATED FAQS
  1. Which economic factors most affect the demand for consumer goods?

    Understand how key economic factors such as inflation, unemployment, interest rates and consumer confidence affect the level ... Read Answer >>
  2. Marginal propensity to consume (MPC) versus marginal propensity to save (MPS)

    Learn the significant roles that the marginal propensity to consume and the marginal propensity to save play in Keynesian ... Read Answer >>
  3. What is the relationship between inflation and interest rates?

    As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. ... Read Answer >>
  4. What's the difference between the income effect and the price effect?

    The price effect is the impact on the market based on how the consumer is spending money as a result of the income effect. Read Answer >>
  5. What economic factors affect savings account rates?

    Find out how supply, demand and central bank policy all affect savings account rates offered by banks for extra deposits ... Read Answer >>
Related Articles
  1. Financial Advisor

    Implications of the Federal Reserve's Impending Rate Hike

    The Federal Reserve begins its two-day meeting on Wednesday, September 16, and everyone is watching to see if the central bank will raise the United States target interest rate for the first ...
  2. Managing Wealth

    Save Money by Analyzing Economic Trends

    It may seem like a tactic for active traders, but following economic trends can help you save and make money.
  3. Insights

    The Impact of a Fed Interest Rate Hike

    When interest rates increase, there are effects on the ways that consumers and businesses can access credit and plan their finances.
  4. Insights

    Comparing marginal propensity to consume: U.S. versus the world

    Learn how the marginal propensity to consume in the United States compares to that of other countries and why the United States is a unique case.
  5. Personal Finance

    How Savings Are Saving The Economy

    Even with inflation fears, saving money is still sage advice in a recovering economy.
  6. Financial Advisor

    High Debt and Savings Rates Hinder China's Economy

    China's recent debt explosion seems odd considering its high savings rate, but the two are related and may provide the key for renewed growth.
  7. Insights

    How the Federal Reserve Affects Individual Investors

    The Federal Reserve's decision on interest rates affects the whole economy.
  8. Insights

    What is Fiscal Policy?

    Fiscal Policy how governments adjust taxes and spending to moderate the economy. Fiscal Policy is the sister strategy to monetary policy, through which a central bank influences a nation's money ...
  9. Insights

    Will Consumer Spending Save the Economy? (FIT, CZR)

    This week will hold incredibly important clues to the state of the American consumer. Be prepared.
RELATED TERMS
  1. Savings Rate

    Savings rate is the percentage of money take from personal income ...
  2. Average Propensity To Save

    The average propensity to save (APS) is an economic term that ...
  3. Marginal Propensity to Save (MPS)

    A marginal propensity to save (MPS) refers to the proportion ...
  4. The Wealth Effect

    The wealth effect in behavioral finance suggests that investors ...
  5. Consumer Discretionary

    Consumer discretionary is an economic sector that comprises items ...
  6. Reference Rate

    A reference rate uses benchmarks, like the prime rate and the ...
Trading Center