- An increase in the base interest rate will lead to an increase in the general cost of borrowing, throughout the economy.
- Also higher interest rates increase the return on saving money in an interest bearing account.
- Therefore consumers will be less willing to borrow, e.g. on credit cards and personal loans.
- Consumers with variable mortgages will have an increase in monthly payments, therefore, they will have a reduction in disposable income.
- This will cause a significant fall in consumer spending, because, in the UK many home owners have mortgage payments, which account for a high % of their income. (This is as a result of rising house prices)
- Similarly, the increase in borrowing costs will also reduce business investment.
- Therefore with a fall in consumption and investment there is likely to be a fall in Aggregate Demand, or more accurately, AD will increase at a slower rate.
- Therefore higher interest rates tend to reduce the rate of economic growth and inflation.
Evaluation of higher interest ratesHowever, the effect of a rise in interest rates depends on various factors.
1. Effect on savings (income and substitution effect)
Higher interest rates encourage savings and therefore reduce consumption (substitution effect). However, higher interest rates also increase income, for those with high levels of savings(income effect). Therefore, some consumers may actually increase spending. For example, in Japan many firms are currently investing out of savings. Therefore, an increase in interest rates is unlikely to discourage investment. In the UK, levels of debt are high and the savings ratio low, therefore, rising interest rates will be more likely to reduce investment and consumer spending in the UK.
2. The state of the economy
If the economy is growing above the trend rate of economic growth and is close to full capacity, a rise in interest rates will have the effect of moderating growth and reduce inflation. However, it is unlikely to cause a recession because the rest of the economy is buoyant. For example, higher interest rates in the late 1980s didn't cause a downturn initially because the economy was buoyant. Though eventually high interest rates of 1990-92 did cause a recession.
3. Depends on consumer confidence
The effect of a rise in interest rates is sometimes hard to predict. If consumer confidence is high then rising interest rates may not discourage spending; people may just be willing to pay more interest. However, at other times a rise in interest rates may adversely effect confidence; therefore, the effect will be much greater. E.g. In the UK, many are concerned about the booming housing market, they feel the boom could soon turn to bust. A rise in interest rates could be the catalyst to stop house prices rising. If house prices fell it would have a significant impact on reducing consumer spending.
4. Effects on exchange rate
Higher interest rates cause hot money flows, because it is more attractive to save money in the UK. Therefore, this will cause an appreciation in the exchange rate. An appreciation will make exports more expensive and imports cheaper. Assuming demand for exports and imports is relatively elastic, then an appreciation will reduce the growth of AD and help reduce inflation. In the UK, the exchange rate has been strong during the past year. Some experts argue it is fundamentally overvalued. Therefore, a further appreciation in the exchange rate would definitely not be welcomed by the exporting sector.
5. Time lag
It is estimated interest rate changes can take up to 18 months to have its full effect. Therefore, an increase in interest rates now, may reduce growth in the future. However in the UK interest rates have been increased from a low of 3.5% in 2003. Therefore, previous interest rates will begin to have an accumulative effect.