Question

As interest rates rise (LO4) a) more borrowing will be undertaken b) less borrowing will be undertaken c) there is no change in the level of borrowing

Short answer

When interest rates rise, borrowing becomes more expensive, leading to a decrease in the level of borrowing. Therefore, the correct answer is \(b)\) Less borrowing will be undertaken.

Step-by-step solution

Understanding Interest Rates and Borrowing

Interest rates are the cost of borrowing money, usually expressed as a percentage of the amount borrowed (principal). When interest rates rise, the cost of borrowing money increases, making it more expensive for individuals, businesses, or governments to borrow money.

Analyzing the Options

We'll analyze each option in the exercise and evaluate its relation to rising interest rates. a) More borrowing will be undertaken: As interest rates rise, the cost of borrowing increases, making it less likely for people to want to borrow money. This option contradicts the general understanding of interest rates and borrowing, so it is not the correct answer. b) Less borrowing will be undertaken: When interest rates rise, the cost of borrowing money becomes more expensive, often causing individuals, businesses, and governments to hesitate or reduce the amount they borrow. This option aligns with the general understanding of how interest rates affect borrowing, making it a plausible answer. c) There is no change in the level of borrowing: This option suggests that interest rates have no impact on borrowing decisions, which is not logical, as interest rates are a significant factor that influences an individual's or entity's decision to borrow money or not.

Selecting the Correct Option

Based on our analysis of the options, the correct answer would be: b) Less borrowing will be undertaken As interest rates rise, borrowing becomes more expensive, leading to a decrease in the level of borrowing.

Key concepts

Economic Principles

Interest rates play a crucial role in a country's economy; they represent the price paid for the use of borrowed money and act as a lever that can either encourage or dissuade borrowing and spending. When central banks increase interest rates, they do so typically to manage economic growth and inflation. Higher interest rates increase the cost of borrowing, discouraging consumers and businesses from taking on new loans and spending money. Conversely, lower interest rates make borrowing more affordable, stimulating investments and purchases.

At the fundamental level, this process adheres to the supply and demand principle. As borrowing becomes more costly due to higher interest rates, the demand for loans tends to decrease because individuals and firms prioritize saving money over expensive debt. Hence, economic principles suggest that as interest rates rise, less borrowing will likely be undertaken, slowing down economic activity to curb inflation and prevent overheating of the economy.

Financial Education

Understanding how interest rates affect borrowing is essential for sound financial education. As an individual or a business, being financially educated means acknowledging that higher interest rates result in more expensive loan repayments. This awareness allows for better personal or corporate financial planning.

Financial literacy includes grasping the concept of 'opportunity cost,' or what one must give up choosing a particular course of action. When interest rates rise, the opportunity cost of taking out a loan increases, since not only does the principal amount of the loan need to be repaid, but also the additional interest which is now larger. Educated borrowers will consider this and might opt to delay big purchases, invest the would-be interest payments elsewhere, or seek out alternative financing options with more favorable terms.

Loan Decision Factors

Several factors influence loan decisions beyond just the current interest rate. These factors often include but are not limited to:

• Credit history and credit score of the borrower
• Loan amount and down payment size
• Loan term or length of the repayment period
• The overall economic environment
• Availability of alternative financing options

Each of these can significantly sway a borrower's decision to take on debt. A high credit score might secure a lower interest rate even in a high general rate environment. Likewise, lenders may offer long-term loans which reduce monthly payments, making borrowing more attractive despite higher rates. However, even with these considerations, the common denominator remains that higher interest rates typically discourage borrowing, aligning with our previous overview of economic principles and financial education.