Interest rates are often described as the price of money, and like any price, they affect behaviour across the entire economy. A change in the base rate set by a central bank sends ripples through mortgages, savings, business investment, exchange rates, and asset valuations — making it one of the most powerful levers in economic policy.
The most direct channel is borrowing. When rates rise, loans become more expensive. Homeowners on variable rate mortgages see their monthly payments increase immediately. Businesses looking to invest in new equipment or expand operations face higher borrowing costs. Both groups cut back. Demand in the economy falls, which cools inflation.
The savings channel works in the other direction. Higher rates make saving more attractive. Households put more money aside and spend less. This further reduces demand.
The exchange rate channel is subtler but significant. Higher interest rates attract foreign capital seeking better returns. This increases demand for the currency, causing it to appreciate. A stronger currency makes exports more expensive and imports cheaper — reducing export competitiveness and reducing import inflation.
Asset prices are also deeply affected. The value of most financial assets — stocks, bonds, property — depends on future cash flows discounted back to today. When rates rise, those discount rates increase, reducing present values. This is why rising rates tend to push stock and bond prices down.
The credit channel matters too. Higher rates increase the risk of borrowers defaulting on existing loans, which can make banks more cautious about lending, further tightening financial conditions.
All of these channels work together. A single rate decision by a central bank eventually touches millions of economic decisions — from whether a family takes out a mortgage to whether a company builds a factory. The lag, however, is real: economists estimate that the full effect of a rate change takes 12 to 24 months to work through the economy.