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.
3. Return on savings increase.


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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.

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  • 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.


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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.

Interest Rates and Exchange Rates

Interest rates also cause an appreciation in the exchange rate. Higher interest rates make it more attractive to save money in the UK. Therefore, this causes hot money flows into the UK and an appreciation in the exchange rate.

See also:
Perma Link | By: T Pettinger | Friday, May 11, 2007
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