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What Is the Connection Between Interest Rates and Economic Growth?

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The relationship between interest rates and economic growth is derived from the use of interest rates as a means for achieving desired economic conditions. That is to say that interest rates are tools used to make the economy more stable by limiting undesirable factors like inflation and rabid consumption by consumers. The authority that is vested with the power to make the changes in the rate of the interest in an economy is the central bank of the country under consideration. Central banks use monetary policies as a means of tinkering with interest rates and economic growth. They usually do this by either increasing or decreasing the rate of the interest on the money that they remit to the other banks in the economy. Economies have cycles that are used as a means of gauging the health of such an economy and any gains that may have been made in the economy by the application of several monetary and fiscal policies. When the parties with vested interest, such as economists, businessmen and businesswomen, the government and the various banks observe the macroeconomic and microeconomic trends after analyzing the periodic economic reports, they will come to various informed conclusions regarding the health of the economy. Where there are unfavorable macroeconomic indicators like rising unemployment and inflation, the central bank might decide to raise the interest rate on the money remitted to the banks. This action establishes a link between interest rates and economic growth, because the purpose of increasing the interest rates is to address the unfavorable elements in the economy that are detrimental to economic growth. For instance, the action of increasing the interest rates will have a domino effect on the other banks — something that can be likened to a knee-jerk reaction. An increase in the interest rates means that they will tighten their lending policies and also increase the rate of interest they pay on savings deposits. When consumers discover that they cannot have the same easy access to different types of finance for their consumption, they will decrease the rate of such consumption. Another link between interest rates and economic growth is seen in the way in which the increase in the interest rates will cause the consumers to save their money for two major reasons. The first is to conserve their money due to the perceived scarcity of such finance, and the second is to take advantage of high interest rates offered by the banks as a means of encouraging savings. When this happens, the activity in the economy will decrease, and the rate of inflation will go down as a result. Just the same, when the central bank decreases the interest rates consumers will have easier access to finances, and the rate of consumption will go up, stimulating the economy.

considering the recent slowdown in economic growth. given the level of resource unemployment –human and material.High Interest Rates: The Impact On Economic Activities And Growth Link: http://www. a period during which excess capacity exists and companies have room to increase production as demand rises. stable long-term interest rates and real exchange rates. This is because prices and wages usually do not adjust immediately. Economists generally agree that in the long run. Perhaps it is also the reason why the policy objective of the Central Bank of Nigeria (CBN) and its monetary policy thrusts are essentially the attainment of price stability and sustainable economic growth. However in the short run. it appears that the objectives generally boil down to adjusting the supply of money in the economy to achieve some combination of inflation control and output stability. when the resources of the economy are in full use. the monetary authority acknowledges the need to create a balance with the other macroeconomic objectives of the Government. Although the focus of monetary policy has shifted largely in favour of price stability. especially with the adoption of ‘inflation targeting’ in 2008.myfinancialintelligence. Associated objectives are those of full employment. In addition. Nevertheless. changes in money supply do affect the actual production of goods and services. While the monetary policy may have been forced to become reactionary –frontloading the liquidity impact of fiscal policy excesses. the level of output is fixed and any adjustment to money supply will only cause prices to change. monetary surpluses/excesses that are . However. the price stability objective of the CBN and the consequent high benchmark interest rate over the last three years may have started to hurt the Nigerian economy.com/banking-and-finance/high-interest-rates-impact-economicactivities-and-growth Monetary policy has been operated with a variety of objectives in mind over the years. This report reviews the effect of the current monetary policy mode on economic activities and growth. economic growth is being compromised in the process. monetary policy is a meaningful tool for achieving both inflation and economic growth objectives. For this reason.

that makes it tougher for them to qualify for loans at any interest rate.36% in 2007 to 23.13% to 12.08% in 2010 before the commencement of the current spate of monetary tightening. An important parameter in that process is the dynamics of the retail lending rate in which the prime lending rate declined compared to an increase in the maximum lending rate between 2009 and 2012. usually corporate organisations. the fall in deposit rates could allow for a substantial spread which would enable banks remain profitable. This could be blamed partly on the curtailment of lending by banks during the global financial crisis as asset prices collapsed. An interest rate hike also makes banks less profitable in general and thus less willing to lend. Directly through the sale and purchase of short term government securities in open market operations. or buildings. The fall in credit demand accompanying a monetary contraction robs the bank of the credit margin which cannot always be substituted for by trading/holding of liquid assets. the MPR declined to as low as 6. indicating a disconnect between the MPR and the retail lending rate at this point. And for businesses. leaving only the potentially bad ones. The first channel of impact is through the aggregate demand on both the output and prices. The retail lending rate has however trended upward even at the low MPR in 2010. The period was characterised by a sharp dry up of bank credit to both the corporate and retail consumers.channelled to productive use are unlikely to cause inflation. While the monetary policy approach to resolving these issues has worked to stabilise the industry. they become less likely to invest in new equipment. and is followed by widespread deleveraging. Theoretically. However. This occurs by making many erstwhile feasible projects unprofitable at a higher hurdle rate as the Weighted Average Cost of Capital (WACC) increases with each interest rate hike. a process called the demand channel. a scenario that may be playing out in Nigeria. projects. The decline in prime lending rates indicates an increased preference to supply credit to selected prime customers. as the regulator battled to sanitise the banking system. or indirectly through the use of the short term benchmark interest rate. Aggregate Demand Channel Has Been Negatively Impacted Economic theory and research outcomes have identified a number of ways through which monetary actions are transmitted to the real economy by altering the amount of money in the economy. However. the reduction in the level of economic activities will push inflation lower because lower demand usually leads to lower prices. borrowing costs increase. . When monetary policy is contractionary or tight as is currently the case in Nigeria. where monetary tightening results in higher real yields on secured and liquid assets. This is called the bank lending channel. including government securities.50% in 2012. It is therefore believed that the perceived structural disconnect in the economy can be helped by balanced monetary policy actions among which a single digit lending rate is central.00%. Impact On Companies’ Balance Sheets An increase in interest rates also tends to reduce the net worth of businesses and individuals. making it less likely for consumers to demand commodities they would normally finance such as houses or cars. During the same period. the monetary policy rate (MPR) rose from an average of 9. directly or indirectly. the punitive classification of risk assets may have raised the bar on credit evaluation thereby weeding out some classes of borrowers. The retail lending rate rose from an average of 18. This is called the balance sheet channel of impact. thus reducing spending and increasing price pressures. It therefore introduces the problem of adverse selection to the lending process –a situation where the level of interest rate weeds out likely quality credits.

While it can be argued that our non-oil export industry is small. These limitations are denying the huge small and medium scale subsector access to finance due to high interest rates and loan policies that rob the nation of substantial complementary growth that could cushion the effects of the structural constraints. For instance. it has been argued and now supported by recent research outcomes that inflation in Nigeria is structural in nature. through the exchange rate channel. Monetary policy also achieves this through expectations—the self-fulfilling component of inflation. Within the parlance of the quantity theory of money. However. such as climate and increased land use in agricultural sector.that offers such a significant return on risk free assets. Inflation In Nigeria Is A Structural Phenomenon The debate on whether inflation is a structural or monetary phenomenon has been ongoing for some time. and foreign appetite for the country’s exports fall. as foreign investors seek higher returns and increase their demand for domestic assets. business production declines. On the other hand. All sectors currently depend largely on natural factors to survive. the major source of government revenue. the naira value of oil export earnings. the adoption of a ₦160/$ exchange rate for the budget 2013 revenue assumption may weaken the government revenue profile in 2013 if the current monetary policy stance sustains the exchange rate at ₦155/$. This is in addition to the sustained positive real return over the last two years as the monetary authority keeps it so at every level of inflation. caused by the myriads of . Although it has been argued in certain quarters that a combination of structural constraints which could not be addressed with monetary policy actions and supply side shocks –flooding for instance –are largely responsible for the slowdown. becomes lower with implications for fiscal expenditure profile and outlook. contrary to the CBN position that inflation in Nigeria is a monetary phenomenon. However. The constrained business environment which continues to keep the economy well below its production possibility frontier is also worthy of note. the surge in foreign portfolio investments has resulted in an increase in the value of the naira in recent times.High rates normally lead to an appreciation of the currency. Another factor is the structural disconnect that allows fiscal excesses to create systemic liquidity without any productive impact with strong implications for price stability. Declining GDP Growth And Lower Inflation Sustained sharp and/or miscalculated monetary policy tightening could push the economy into a recession where consumers tend to cut down on spending to as low as subsistence. exports become less competitive with their volumes reduced as they become more expensive. The resolution of these issues is at the heart of a balanced monetary policy framework. The implication of this is that the increase in the prices of goods and services. leading firms lay off workers and stop investing in new capacity. a very strong possibility. grow faster and provide mass employment with sound financial inclusion premised on affordable credit. At over 12% yields on government securities. This happens when consumers are broke and firms cut back on hiring and spending. monetary tightening pushes the economy towards the point where less money chases more goods. The recent surge in foreign portfolio investment alludes to this. Nigeria appears to be the only country with a sovereign risk rating of BB. leading to a decline in the general price level as we have seen in recent times. the level of imports rises as they become cheaper. And many of them will perform better. In return. The recent slowdown in the Gross Domestic Product (GDP) growth is indicative in this regard.

while inflation rose but remained in single digits for most of the period. as proven by the positive outcomes of some of the recent rules around interbank and foreign exchange market activities. Investment in infrastructure was also modest with high expectations upon which long term productive investments could be made.80% as the exchange rate stabilised and the adjustment was priced into costs. net credit to the economy. The periods of monetary easing through 2009-2010 coincided with a peak in inflation. While they tend to have the same effect on short term market rates. And in those periods. between 2007 and 2008. 176. The global recession which started in 2008 and the oil production shock caused by the Niger Delta insurgence arguably contributed to the volatile economic conditions afterward. This suggests that barring structural constraints. a targeted approach will have a more positive impact on economic activities as businesses can access longer term finances (through the capital market) at relatively cheap rates. This is because a monetary policy system that monitors the flow of liquidity and uses the open market operation to mop up any excessive and unproductive injections directly will do better than a generalised benchmark interest rate that punishes all sectors of the economy regardless of whether they benefit from the liquidity flow. perhaps a lag effect of earlier monetary expansion and primarily due to the sharp depreciation of the naira. is very high. In addition. which regulates aggregate demand.9% and 72. Therefore. Effective Inflation Management The problem of unproductive liquidity injections from fiscal excesses has been identified. economic growth was also high. It has been argued that this effect is big enough to sustain inflation rate in the double digit region if the monetary contraction continue to add to the supply side problems. given the typically high marginal propensity to consume in an economy with vast idle resources and high absorptive capacity. An important task in this regard is working with the fiscal authority on the roles of the monetary authority in the development strategy of the government.60% to 11. Monetary Easing With Declining Inflation The 2007/08 period was preceded by strong institutional development and fiscal commitment to economic liberalisation. would suffice at managing such liquidity. and credit to the private sector grew at an average annual rate of 52. And investment was growing alongside aggregate demand in an environment of both high liquidity and monetary accommodation. Policy Reversal Review Is Imminent The monetary policy has a strong role to play in expanding financial inclusion and ensuring that proper financial intermediation other than securities trading remains the hallmark of the banking system. It was also the period of major moderation in inflation from the peak of 15. Monetary aggregates –broad money. it is believed that targeted market rules and regulations as well as quantitative monetary interventions and incentives. what monetary tightening does is to simply add to the constraints and force down aggregate demand and prices with limited impact. The problem is a product of the structural disconnect in our economy which allocates the highest financial flows to the smallest contributor to growth. One argument that highlights this conclusion is the fact that inflation rate were at their lowest during the period of accommodating monetary policy in 2007-08. and this could compound systemic liquidity and pose a threat to exchange rate stability and price levels. it might as well be a result of the global economic recession.supply side constraints especially infrastructural challenges. may be more effective. high liquidity will not necessarily cause inflation. The current weakness of that handshake is constraining the monetary authority to a reactive stance at the expense of a supportive monetary policy direction. .10% per month respectively.80%. In the presence of heavy structural constraints. a money-based policy otherwise known as quantity-based anchor.

would increase their share of GDP while the increasing aggregate supply is likely to create competition that would have a positive inflationary effect. In the run up to a new year and the attendant monetary policy course.particularly in relation to interest rates. . and construction. especially the food and beverages. housing. Other sectors such as manufacturing. Such a review will increase access to finance for small scale businesses that are major employment creators. it must be noted that the Nigerian economy faces its own economic cliff to which a commencement of monetary tightening reversal and a comprehensive review of the financial intermediation process and policy transmission channels is important.

Investors want to preserve the "purchasing power" of their money. Consumers might be buying cars and houses. The trouble is. this "tightens" monetary policy and causes interest rates to rise. Monetary Policy Another major factor in interest rate changes is the "monetary policy" of governments. As inflation dropped. Governments alter the "money supply" to try and manage the economy. For example. Therefore interest rates go up! If the banks and trust companies have lots of money to lend and the housing market is slow.com/interest. A high level of government expenditure and borrowing makes it hard for companies and individuals to borrow. inflation moved from the 2-3% range to above 12%! The investor was receiving 7% less than inflation. This causes economists endless debate. This makes interest rates lower.htm When interest rates change. Simply put. Since interest rates reflect human activity. People who study interest rates find that it is as difficult to forecast future interest rates as it is the weather. available for loans from lenders. The trouble is. In a booming economy. take the mortgage market. effectively reducing the investor's wealth in real terms by 7% each year! . no one is quite sure how much money is necessary and how it is actually used once it is available. If the supply of money is lowered. banks and trust companies need to have the funds available to lend. Supply and Demand for Funds Interest rates are the price for borrowing money. After lending money at 5-6%. How governments spend their money and finance is called "fiscal policy". and the demand. After the very high inflation years of the 1970s and early 1980s. Imagine the plight of the long-term bond investor in the high inflation period. If a government "loosens monetary policy". If the demand for borrowing is higher than the funds they have available. this source of funds is more expensive. the Central Bank creates more money by printing it. from borrowers. and even acquire other firms. any borrower financing a house will get "special rate discounts" and the lenders will be very competitive. These keep the "demand for capital" at a high level. because more money is available to lenders and borrowers alike. The banks pay 6% interest on five year GICs and charge 8% interest on a five year mortgage. They can get these from their own depositers. Interest rates move up and down. this is called the "crowding out" effect. many firms need to borrow funds to expand their plants. finance inventories. This happens in the fixed income markets as a whole. a long-term forecast is virtually impossible.Link: http://www. keeping rates low. After the fact. Inflation Another very important factor is inflation. If inflation is high and risks going higher. In a period when many people are borrowing money to buy houses. and interest rates higher than they otherwise might be. investors then demanded lower rates as their expectations become lower. this means that it has "printed more money". The most important among these is the supply of funds. explanations are many and confident! Some of the major factors which help to dictate interest rates are explained below. Governments also borrow if they spend more money than they raise in taxes to finance their programs through "deficit financing". reflecting many factors. it is the result of many complex factors. they can raise their rates or borrow money from other people by issuing bonds to institutions in the "wholesale market". investors will need a higher interest rate to consider lending their money for more than the shortest term. lenders had to receive a very high interest rate compared to inflation to lend their money.finpipe.