Cost of Borrowing / Savings & Investment Incentives

A Channel of the Transmission Mechanism

How Households and Businessess change their decisions on whether to save, or Borrow (Invest) as a result of changes in; “The cost of borrowing”, and the “opportunity cost of spending”, both of which are influenced by Interest Rates.

🠱Cash Rate (Contrac.) §

Households Increase their savings as Interest Rates increase because of;

• The Opportunity Cost of spending is higher, they could instead invest their money in a Interest-earning account and get greater Interest Receipts as Interest Rates rise.
• Increased Cost of Borrowing, higher Interest Rates mean you must make greater Income payments for the same amount of funds.

Businesses also borrow to invest, as Interest Rates rise;

• The increased Cost of borrowing means there is a decrease in demand for business loans.
  • Because the increased cost means a lower potential return on investment.

⬇Cash Rate (Expan.) §

Expansionary Monetary Policy is generally less effective in a contraction or trough. Businesses do necessarily react to lower costs of borrowing during periods of low economic confidence in prospects while Aggregate Demand is low. A pertinant example is in recent years with record low interest rates of 0.1%, yet Investment was still low. Lower Interest Rates can encourage household borrowing, as they can pay lower repayments