Effects of Raising Interest Rates
If a central bank increases the base rate, this tends to increase all major interest rates in the economy. This means interest rates for both savers and borrowers will increase.
Higher interest rates will have various economic effects:
- Increases the cost of borrowing. Interest payments on credit cards and loans will be more expensive. Therefore this discourages people from borrowing and saving. People who already have loans will have less disposable income because they spend more on interest payments. Therefore other areas of consumption will fall.
- Increase in mortgage interest payments. Related to the first point is the fact that interest payments on variable mortgages will increase. This will have a big impact on consumer spending. This is because a 0. 5% increase in interest rates can increase the cost of a £100,000 mortgage by £60 per month. This is a significant impact on personal disposable income and will lead to lower spending in the economy.
- Increased incentive to save rather than spend. Higher interest rates make it more attractive to save in a deposit account because of the interest gained from saving
- Higher interest rates increase the value of exchange rate. For example, if UK interest rates increase relative to other countries, investors are more likely to save in British banks because they get a better rate of return. A stronger pound makes UK exports less competitive and imports cheaper. This reduces exports and increases demand for imports.
- Rising interest rates affect both consumers and firms. Therefore the economy is likely to experience falls in consumption and investment.
- Government debt interest payments increase. The UK currently pays over £40bn a year on its own national debt. Higher interest rates increase the cost of government interest payments. This could lead to higher taxes in the future.
- Reduced Confidence. Interest rates have an effect on consumer and business confidence. A rise in interest rates discourages investment; it makes firms and consumers less willing to take out risky investments and purchases.
Therefore, higher interest rates will tend to reduce consumer spending and investment. This will lead to a fall in Aggregate Demand.
Effect of Higher Interest Rates - AD/AS
In this AD/AS diagram, higher interest rates have reduced AD causing lower real GDP and lower inflation.
Evaluation on the impact of increasing interest rates
- It affects people in different ways. The effect of higher interest rates will affect different groups of consumers in different ways. Those consumers with large mortgages (often first time buyers in the 20s and 30s) will be disproportionately affected by rising interest rates. For example, reducing inflation may require interest rates to rise to a level that cause real hardship to those with large mortgages. However, those with savings may actually be better off because they get more income from their saving.
- Time lags. The effect of rising interest rates can often take up to 18 months to have an effect. For example, if you have an investment project 50% completed, you are likely to finish it off. However, the higher interest rates may discourage starting a new project in the next year.
- It depends upon other variables in the economy. At times, a rise in interest rates may have less impact on reducing the growth of consumer spending. For example, if house prices continue to rise very quickly, people may feel that there is a real incentive to keep spending, despite the rise in interest rates.
- Real Interest Rate. It is worth bearing in mind that what is important is the real interest rate. The real interest rate is nominal interest rates minus inflation. Thus if interest rates rose from 5% to 6% but inflation rose from 2% to 5.5 %. This actually represents a cut in real interest rates from 3% (5-2) to 0.5% (6-5.5) Thus in this circumstance the rise in nominal interest rates actually represents expansionary monetary policy.
Example of Higher Interest Rates - Late 1980s in UK
- From 1988 to 1990, UK interest rates were increased from 8% to 15%.
- This was a significant factor in causing a fall in house prices, and the recession of 1991-91.
Hihger interest rates in 1988-1990 saw the UK growth rate fall from 5% to -1.4%