please explain what is the relavance of the level of interest rate in an economy growing at a high rate? should the interest rate be less than the growth rate? or should it be more than growth rate or should be similar?
Firstly, it is important to be aware of the real Interest Rate.
- Real interest Rate = Nominal Interest Rate – Inflation
- UK interest rates = 5.75%: Inflation = 2.7%. Therefore real interest rate = 3%
- Basically, if you save money then after the effects of inflation, the purchasing power of your money will increase by 3%.
- If inflation in the UK was 5% it means that the real interest rate would be: 0.75%
Effect of Interest Rates
Interest rates are used by the MPC to control inflation and economic growth.
For example, because there have been inflationary pressures in the UK economy, the MPC increased nominal interest rates.
Higher interest rates reduce the growth of consumer spending and economic growth. This is because:
1. More incentive to save in a bank rather than spend
2. More expensive to borrow, therefore less spending on credit and less investment
3. Increases cost of mortgage repayments, therefore, reduces disposable income and therefore consumer spending
Therefore, because the MPC feel the UK economy is growing too fast (currently just under 3%) they believe inflation could occur and therefore they are increasing interest rates to reduce the rate of growth. They hope higher interest rates will avoid future problems of inflation and a boom and bust economy.
see also: interest rates explained
Chinese Economic Growth
- In 2007 the (real) rate of economic growth in China is 10-11%.
- The nominal rate is 14% - inflation of 3%.
- Inflation in China is just above the 3% comfort level, but some economists feel it could rise on the back of a shortage of goods and raw materials
- Therefore, with economic growth of 10% in China, you would expect inflation to be more of a problem. UK’s growth is 7 % points less yet has the same interest rate as China.
Why China should increase interest rates.
- Higher interest rates would reduce the rate of economic growth in China to a more manageable level. Therefore, it would avoid inflation and maintain sustainable economic growth (avoid boom and busts)
- Inflation worry hits china at BBC
- Evidence of property boom in key cities
- Banks lending is getting out of control
Why China doesn't increase interest rates.
- Well inflation is still relatively low.
- China’s economic growth is different to the UK, there is still a lot of spare capacity because:
- High level of labour willing to work at low wages (supply is elastic in economic terms)
- Spare capacity from privatisation of inefficient state industries.
- Unemployment is a problem in China, despite very high growth levels.
Chinese Yuan undervalued?
Related to the low interest rates is the fact China keeps its currency devalued. By having a weak currency it makes Chinese exports cheaper. This boosts export sales and maintains high growth. Allowing the exchange rate to appreciate would have a similar effect to raising interest rates. Although again, the reason they don’t is that they are fearful higher exchange rates will damage economic growth and cause unemployment.