How Can a Rise in the Lending Rates of the Commercial Banks Affect the Economy?

Rising lending rates generally slow down (“cool off”), even contract, an economy. Inflation goes down as amount of money in circulation decreases. In a simple case, currency gains value. Imported products become more affordable. Companies with high operating debt are hurt. Debt-free companies get a competitive advantage.
  1. Lower Inflation

    • Higher rates protect against runaway inflation. The rising rates effectively decrease the amount of money in circulation.

    Stronger Currency

    • Higher rates reduce the money supply while keeping the value and demand (approximately) constant. A constant amount of wealth distributed over fewer units of currency makes each unit proportionately more valuable.

    Cheaper Imports

    • Since each dollar carries more value, it provides more products made in regions with weaker currency.

    High-Debt Companies

    • Assume Corporation D needs to borrow $1.00 at 3% to make $1.05. After paying back $1.03 for every dollar borrowed, Corporation D is left with $1.02 (1.05 - 1.03) profit. If interest rate passes 5%, Corporation D is running at a loss.

    Debt-Free Companies

    • Rising borrowing rates are an indirect benefit to companies with zero debt. Those that must borrow to survive, such as Corporation D, are hurt by the rising rates. A debt-free company is not directly affected by rising rates on borrowed money. It has an advantage over debt-reliant competitors.

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