Readers Question. Explain how interest rates could be used to boost the economy. Why, then do the govenment frequently hesitate to take such steps.
Interesting Question.
Generally, lower interest rates help increase consumer spending, investment and economic growth. Lower interest rates help increase Aggregate Demand for various reasons.
- Lower interest rates make borrowing cheaper encouraging investment and spending
- Lower interest rates make mortgage payments cheaper, increasing disposable income of consumers.
- Less incentive to save. Therefore increased incentive to spend
- Lower exchange rate, making exports cheaper and boosting AD.
Most people in the economy like to see interest rates cut, especially homeowners and businessmen. Why then do Governments or Central Banks hesitate to cut rates?
- Lower interest rates can cause inflation. If Aggregate Demand increases faster than aggregate Supply, the economy will experience inflation. Inflation is said to create instability and uncertainty in the economy.
- The higher growth may be unsustainable. In the 1980s, the UK government cut interest rates (in response to the stock market crash of 1987, this caused rapid economic growth of 5%. People talked of an economic miracle. However, this boom didn’t last, inflation shot up and then the economy went into recession. Therefore, it is better to have moderate growth of 2.5%, rather than growth of 5% which leads to boom and bust.
- Interest Rate cuts can cause housing and credit booms. In 2002, the US cut interest rates to 1.5% to stimulate the economy. This encouraged a boom in the housing market, prices rose above long term trends, and this caused a property boom that is now unravelling.
- Since 1997, the MPC have been made independent. However, their primary objective is low inflation, CPI inflation of 2%. Therefore, the MPC are currently reluctant to cut rates, because inflation may still go above target.
However, the decisions of Central Banks are often criticised. For example, many think the MPC should cut interest rates now to avoid the UK going into recession. One member of the MPC, Prof D.Blanchflower is critical of the MPC’s reluctance to cut rates.