Economic Theory

“Moreover, contrary to the what economic theory suggests, higher interest rates have not caused everyone to borrow less for consumption. Most people are borrowing as much as ever – or more – to buy goods now”.

Question: Are economists wrong in saying that consumption depends negatively on interest rate? (5 marks)

The economists are not “wrong” in claiming consumption depends negatively based on interest rates as economic theory suggests consumption is inversely related to interest rates. In theory, an increase in interest rates should deter people from consumption and borrowing to fund consumption as the opportunity costs of a loan (i.e. the nominal interest rate) would have rinsed. Doubly, a higher increase should encourage consumers to save as a higher interest rate makes savings more attractive as the return on savings (interest) would have also risen. However as mentioned before this relationship is theoretically based and interest rates are not the sole influence on consumption.