Certified Financial Management Specialist Practice Exam

Which of the following best describes the impact of interest rates on economic activity?

1. Higher rates boost economic activity

2. Lower rates discourage saving

3. Rising rates reduce spending and borrowing

4. Interest rates do not affect economic activity

The correct answer is: Rising rates reduce spending and borrowing

Rising interest rates reduce spending and borrowing, which is a key mechanism through which monetary policy influences the economy. When interest rates increase, the cost of borrowing rises, leading consumers and businesses to either reduce their debt or refrain from taking on new loans. Higher rates create a disincentive to borrow because the repayment amounts become more expensive, negatively impacting discretionary spending and investment decisions. As a result, increased interest rates can slow down economic growth. Consumers may choose to save more instead of spending, and businesses may cut back on capital expenditures. This leads to an overall reduction in aggregate demand within the economy, which can cause slower economic growth or even contraction. In contrast, lower interest rates generally encourage borrowing and spending, fueling economic activity. Higher rates, therefore, act to curb inflation by making credit less accessible, but they can also hinder growth when rates rise too quickly or to excessively high levels.