1. Discuss the consequences for an economy of an increase in interest rates. (25marks)
Interest rate is the effective rate paid on borrowed money. Increasing interest rates is a contractionary monetary policy i.e. the government is aiming to decrease aggregate demand by decreasing consumption and investment, to keep inflation under control when the economy is overheated.
The effects of an increase in interest rates can be analyzed using two approaches, Keynes and Monetarist approach. Under the Monetarist approach, the demand for investment is interest inelastic and an increase in interest rates (from r1 to r2) will lead to a more than proportionate decrease (I1 to I2) in investments.
An increase in interest rates may also help reduce households’ consumption because if interest rates are too high, consumers may not want to borrow to spend as they would have to pay back even more. This is especially so in the case of durable goods such as automobiles. Also, an increase in interest rates will encourage savings due to the higher returns thereby reducing consumption as well.
As a result of the decrease in consumption and investments, there will be a decrease in the aggregate expenditure of the economy to the level of full employment (Yfe) thereby reducing inflation.
However, under the Keynes approach, the demand for investment is interest inelastic and an increase in interest rate (from r1 to r2) will be met with an unresponsive change in investment (I1 to I2) hence the effect of interest rates on investment is less certain. This is because the investments largely depend on the confidence of future markets as well. If confidence is high, firms will continue to invest even if interest rates are high. Firms might pass the higher costs to consumers thereby worsening inflation.
In addition increasing interest rates would not reduce consumption as effectively if consumption is dependent on disposable income rather than interest rates.
The increase in interest rate will only work if the inflation is one that is demand-pull inflation. Since increasing interest rates is followed by unemployment and a cost-push inflation is also followed by a recession, increasing interest rates will only worsen the recession and inflation as it further increases the costs of production, hence it is inappropriate for cost-push inflation.
An increase in interest rates can also affect the external balance of the economy. An increase in interest rates can attract more capital inflows to the country due to the higher returns. As such there might be an improvement in the capital accounts of the Balance of Payments.
In addition, increasing interest rates might not be effective when the degree of control of the Central Bank on commercial banks’ credit-creating ability is low (due to emergence of subsidiary agencies like finance companies) and when there are alternative sources of funds to finance projects.
Increasing interest rates to achieve low rates of inflation and to stabilise the economy only works if the inflation in demand-pull. The effects of interest rates also depend on each economy and can vary for different countries. To have a more certain impact on the economy, fiscal policy should be adopted with monetary policy.
- Higher interest rates lead to hotmoney flows (it becomes more attractive to save in UK) and therefore an appreciation of the exchange rate. A stronger currency will make exports more expensive and help to reduce AD. A stronger exchange rate will also help reduce inflation (lower AD, cheaper imports) An appreciation can worsen the current account if the ML condition is satisfied.
However the effect depends upon the elasticity of demand. If Demand is elastic it will reduce AD and worsen the current account. If inelastic the opposite will occur.
- The effect of increasing interest rates may take time to have effect, upto 18 months.
- It is very rare for A level students to be able to look at the keynesian and monetarist views of raising interest rates. You have some good evaluative points in your essay. - Like depends on type of inflation and depends on confidence. That is good.