Explaining Lower Interest Rates

Readers Question Expansionary stance of monetary policy will lead to a lower interest rate thus discouraging hot money (portfolio I) leading to less outflow of Y and improve CAD. (based on lecturer’s notes)

Doesn’t the discouraging of portfolio I lead to spending more than S and Outflow>inflow thus leading to worsening of CAD??? I’m awfully confuse now. Please clarify and thank you.

If interest rates are cut, there will be less hot money flows into the UK. The UK will be less attractive as a place for investors to save. Therefore, there is less demand for sterling on the foreign exchange markets. This causes a depreciation in the exchange rate.

However, just because there is less demand for sterling on the foreign exchanges doesn’t mean lower Consumer spending. (I assume CAD = consumers Aggregate Demand)

A lower exchange rate will actually boost Aggregate demand in the UK. Firstly exports are more competitive therefore higher demand for exports. But, also imports will be more expensive therefore, people will be discouraged to buy imports and therefore buy more domestic goods.

Lower interest rates will increase consumers spending in the UK because:

• Less attractive to save
• Mortgage payments are lower therefore more disposable income
• Loans are cheaper encouraging borrowing.

THerefore lower interest rates definitely (ceteris paribus) increase consumer spending