Friday, May 11, 2007

Interest Rates explained

With MPC recently increasing interest rates. It may be worth explaining in simple terms the economic effects of a rise in interest rates


Effect of an Increase in interest Rates.

  1. Cost of Borrowing is more expensive.
  2. Mortgage and loan repayments increase. This reduces consumer disposable income
  3. Return on savings increase. More attractive to save.
  4. Causes an appreciation in the exchange rate due to hot money flows.
  5. Fall in asset prices. Higher interest rates can make it less attractive to buy a house with a mortgage leading to lower house prices.

1.1 If borrowing is more expensive consumers will take out fewer loans. Firms will borrow less. Therefore consumer spending and investment will fall (or increase at slower rates)

1.2 Higher mortgage payments reduce disposable income so consumer spending will be lower.

1.3. Saving is more attractive, so this will also reduce consumer spending.

1.4. Appreciation in exchange rate makes exports more expensive, leading to lower export demand.

1.5. Falling house prices create a negative wealth effect and lower consumer spending.

  • If Consumer Spending and Investment falls, this will lead to lower AD. Therefore this cause a fall in Real GDP, or fall in rate of economic growth.
  • Lower growth will tend to increase unemployment. With less output, firms demand less workers.
  • Lower growth will also help to reduce inflation.

Evaluation of Interest rate increases

1. Depends on situation of Economy.

If the economy is at full capacity a rise in interest rates may reduce inflation, but not growth. However, if there is already spare capacity then rising interest rates could cause a recession.

2. Depends on Other Components of AD.

For example, if exports are rising, or if consumers confidence is high; rising interest rates may not reduce AD. For example, in the UK interest rates have risen 2% since 2003, however, consumer spending is still strong.

3. Income effect of higher interest rates.

Higher return on saving may give some consumers a high income. This will be consumers like pensioners. However, in the UK, the savings ratio is quite high, therefore the income effect of a rise in interest rates is likely to be quite low. The substitution effect will be higher.

4. It depends whether Commercial banks pass interest rate cut onto consumers. In Credit crunch, banks didn't reduce their Standard Variable Rate as much as the Bank of England cut its base rate.

In Credit Crunch of 2008, lower interest rates failed to boost economic growth.


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