Interest rates have been used as an important policy tool to prevent inflation. Central Banks adjust interest rates to correct supply and demand imbalances and hence solve the menace of inflation in their respective countries. The central bank would increase interest rates when inflation is higher than what the central bank deems as fit for the country, while, it would reduce interest rates when inflation is below the target level. But do interest rates really work in the way that they are intended to?

**How are interest
rates supposed to work?**

To keep it simple, higher interest rates make loans more expensive due to the higher interest payments. Thus, people would reduce the quantity of loans they take to finance the purchase of goods and services. This in turn would reduce aggregate demand in the economy, ultimately reducing inflation.

On the other hand, higher interest rates would incentivise people to save more money and deposit it at financial institutions since the return on these deposits would be higher.

Thus, a higher interest rate is supposed to shift consumer preference from consumption towards savings, which would reduce overall demand in the economy and ultimately reduce inflation. The converse is true for lower interest rates.

Above is the conventional theory on how interest rates are supposed to work. But is this actually true?

**Do they actually
work in the above way?**

**Consumption**

A measure for consumption in a country would be *Private Final Consumption Expenditure*
i.e. the percentage of national income which people in a country spend and do
not save.

Using data from the would bank website, we can calculate the correlation between private final consumption expenditure and interest rate in a country. Using the above theoretical knowledge one would expect the correlation (correlation lies between -1 and 1, with -1 showing perfect negative correlation and 1 signifying perfect positive correlation) to be negative i.e. as interest rates rise, final consumption expenditure as a percentage of national income would fall. Below is the table with this correlation for the top 10 countries in the world measured by Gross Domestic Product

The above data seems to contradict the conventional theory of the relationship between consumption and interest rates, since some countries have a negative correlation, while others have a positive correlation.

**Savings**

A measure for savings in a country would be the *Gross Savings Rate *i.e. the percentage of national income which the people of a country prefer to save rather than spend. Conventional theory would say that interest rates and savings should be positively correlated i.e. as interest rates rise so should the savings rate of the country. Below is a table which has the correlation for the top 10 countries measured by Gross Domestic Product.

Once again, the above data seems to contradict the conventional theory. There is again a mix of negative and positive correlation for the above countries.

Thus, from the above data it can be seen that the conventional theory on how interest rates are supposed to work hold for some countries but not for others. More importantly, the above data also throws up interesting results when plotted along with the countries per capita income.

**Correlation and
Per Capita Income **

**Consumption**

Below is a diagram which plots the correlation between interest rates and private final consumption expenditure (from the above table) on the Y-axis (Vertical axis) and the corresponding country’s Per Capita Income on the X-axis (Horizontal axis).

We can see from the above diagram that countries with lower per capita income seem to have a positive correlation between final consumption expenditure and interest rates. While countries with higher per capita income seem to have a negative correlation between interest rate and savings rate.

Thus, the “higher income” countries seem to follow the conventional logic of how interest rates are supposed to work, while, the “lower income” countries contradict this logic.

The trend line (regression line) reinforces this relation i.e. as the per capita income of a country rises, the relation between interest rate and consumption moves from being positively correlated towards being negatively correlated.

**Savings**

Below is a diagram which plots the correlation between interest rates and gross savings rate (from the above table) on the Y-axis (Vertical axis) and the corresponding country’s Per Capita Income on the X-axis (Horizontal axis).

The above diagram shows that countries with lower per capita income have a negative correlation between savings and interest rates. On the other hand, countries with higher per capita income have a positive correlation between savings and interest rates.

Thus, just like consumption, the “higher income” countries seem to follow the conventional logic of how interest rates are supposed to work, while, the “lower income” countries contradict this logic.

The trend line (regression line) reinforces this relation i.e. as the per capita income of a country rises, the relation between interest rate and saving moves from being negatively correlated towards being positively correlated.

The above in now way questions the effectiveness of interest rates in dealing with inflation since the correlation between inflation and interest rates shows that higher interest rates reduce inflation, this only questions the way in which interest rates work.

For the “higher income” countries there is no problem since interest rates seem to work in the way they are intended to, the problem arises for “lower income” countries. The above shows that as countries become richer, they tend to converge to the conventional theory how interest rates are supposed to work, but was long as they are still “lower income” they contradict this logic. More research would be required for the possible explanations of this contradiction which would be the matter of a different article.