Cambridge IGCSE Economics 0455 – Households: Influence of the Rate of Interest
Microeconomic Decision‑makers – Households
Objective
To understand how the rate of interest influences households’ decisions on spending, saving and borrowing.
1. Why the interest rate matters
The interest rate is the price of money. It represents the cost of borrowing and the reward for saving. Changes in this price affect three key household choices:
How much to spend on current consumption.
How much to save for future needs.
Whether to borrow for big purchases such as houses or cars.
2. Effect on Consumption (Spending)
When the interest rate rises:
Borrowing becomes more expensive – the cost of financing purchases (e.g., a mortgage) increases.
Households may postpone or reduce discretionary spending to avoid higher loan repayments.
Higher rates also increase the opportunity cost of using cash now rather than saving it.
Conversely, a fall in the interest rate makes credit cheaper, encouraging higher current consumption.
3. Effect on Saving
Savings are influenced by the “reward” side of the interest rate.
Higher interest rates increase the return on deposits, bonds and other interest‑bearing assets, making saving more attractive.
Lower interest rates reduce the return, potentially discouraging saving and prompting households to seek alternative assets or increase consumption.
The real interest rate, which adjusts for inflation, is the relevant measure for saving decisions:
\$r = i - \pi^{e}\$
where r = real interest rate, i = nominal interest rate, and \pi^{e} = expected inflation.
4. Effect on Borrowing
Borrowing decisions depend on the comparison between the interest cost and the expected benefit of the financed purchase.
If the interest rate is low, the present value of future repayments is smaller, encouraging borrowing.
If the interest rate is high, the present value of repayments rises, deterring borrowing.
Households also consider the “interest‑rate elasticity of borrowing,” which measures how sensitive the quantity of credit demanded is to changes in the rate.
5. Summary Table of Effects
Change in Interest Rate
Effect on Consumption
Effect on Saving
Effect on Borrowing
Increase
↓ Current spending (credit more expensive)
↑ Incentive to save (higher return)
↓ Demand for loans
Decrease
↑ Current spending (cheaper credit)
↓ Incentive to save (lower return)
↑ Demand for loans
6. Graphical Representation (Suggested Diagram)
Suggested diagram: Household budget constraint showing the shift when the real interest rate changes – a steeper slope indicates a higher real interest rate, reducing the feasible consumption‑saving combinations.
7. Example Calculation
Suppose a household can either:
Save $1,000 today at a nominal interest rate of 5% for one year.
Borrow $1,000 today at the same rate and spend it immediately.
If expected inflation for the year is 2%, the real interest rate is: