Interest rates determine the amount of interest payments that savers will receive on their deposits.
- An increase in interest rates will make saving more attractive and should encourage saving.
- A cut in interest rates will reduce the rewards of saving and will tend to discourage saving.
However, in the real world, it is more complicated. The link between interest rates and saving is not clear because many factors affect saving
Income and substitution effect of higher interest rates.
- If interest rates fall, the reward from saving falls. It becomes relatively more attractive to hold cash and/or spend. This is the substitution effect – with lower interest rates, consumers substitute saving for spending.
- However, if interest rates fall, savers see a decline in income because they receive lower income payments. A pensioner relying on interest payments from saving may feel he needs to save more to maintain their target income from savings.
Usually, the substitution effect dominates. Lower interest rates make saving less attractive. But, for some, the income effect may dominate, and people may respond to lower interest rates by saving more to maintain their standard of living.
Alternatively, a lower interest rate may encourage other forms of saving and investment. With very low bank rates, it has encouraged people to look for better yields in the stock market. This is one reason why the stock market did well in the great recession of 2008-2013 – savers have been buying shares to get a better rate of interest rate than they can in a bank and on bonds