Investment and the Rate of Interest

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An explanation of how the rate of interest influences the level of investment in the economy. Typically, higher interest rates reduce investment, because higher rates increase the cost of borrowing and require investment to have a higher rate of return to be profitable. Private investment is an increase in the capital stock such as buying …

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Effect of lower interest rates

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A look at the economic effects of a cut in interest rates.

Summary

Lower interest rates make it cheaper to borrow. This tends to encourage spending and investment. This leads to higher aggregate demand (AD) and economic growth. This increase in AD may also cause inflationary pressures.

In theory, lower interest rates will:

  • Reduce the incentive to save. Lower interest rates give a smaller return from saving. This lower incentive to save will encourage consumers to spend rather than hold onto money.
  • Cheaper borrowing costs. Lower interest rates make the cost of borrowing cheaper. It will encourage consumers and firms to take out loans to finance greater spending and investment.
  • Lower mortgage interest payments. A fall in interest rates will reduce the monthly cost of mortgage repayments. This will leave householders with more disposable income and should cause a rise in consumer spending.
  • Rising asset prices. Lower interest rates make it more attractive to buy assets such as housing. This will cause a rise in house prices and therefore rise in wealth. Increased wealth will also encourage consumer spending as confidence will be higher. (wealth effect)
  • Depreciation in the exchange rate. If the UK reduce interest rates,  it makes it relatively less attractive to save money in the UK (you would get a better rate of return in another country). Therefore there will be less demand for the Pound Sterling causing a fall in its value. A fall in the exchange rate makes UK exports more competitive and imports more expensive. This also helps to increase aggregate demand.

Overall, lower interest rates should cause a rise in Aggregate Demand (AD) = C + I + G + X – M. Lower interest rates help increase (C), (I) and (X-M)

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UK interest rates

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UK interest rates were cut in 2009 to try and increase economic growth after the recession of 2008/09, but the effect was limited by the difficult economic circumstances and the after-effects of the global credit crunch.

AD/AS diagram showing effect of a cut in interest rates

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If lower interest rates cause a rise in AD, then it will lead to an increase in real GDP (higher rate of economic growth) and an increase in the inflation rate.

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How do interest rates affect savers and saving levels?

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Interest rates determine the amount of interest payments that savers will receive on their deposits.

  • An increase in interest rates will make saving more attractive and should encourage saving.
  • A cut in interest rates will reduce the rewards of saving and will tend to discourage saving.

However, in the real world, it is more complicated. The link between interest rates and saving is not clear because many factors affect saving.

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In 2009, the household saving ratio increased from 0.5% to over 8% – despite a cut in interest rates from 5 to 0.5%. This was because the impact of the recession encouraged saving. The fear of unemployment and recession was greater than the effect of lower interest rates

Income and substitution effect of higher interest rates.

  • If interest rates fall, the reward from saving falls. It becomes relatively more attractive to hold cash and/or spend. This is the substitution effect – with lower interest rates, consumers substitute saving for spending.
  • However, if interest rates fall, savers see a decline in income because they receive lower income payments. A pensioner relying on interest payments from saving may feel he needs to save more to maintain their target income from savings.

Usually, the substitution effect dominates. Lower interest rates make saving less attractive. But, for some, the income effect may dominate, and people may respond to lower interest rates by saving more to maintain their standard of living.

Alternatively, a lower interest rate may encourage other forms of saving and investment. With very low bank rates, it has encouraged people to look for better yields in the stock market. This is one reason why the stock market did well in the great recession of 2008-2013 – savers have been buying shares to get a better rate of interest rate than they can in a bank and on bonds.

Base rates and bank rates

Usually, a cut in Central Bank base rates leads to an equivalent fall in bank rates. However, in the aftermath of the credit crunch, bank rates didn’t fall as much as base rates. In the UK, bank rates (e.g. Libor were higher). Therefore, the cut in base rates didn’t have as much impact. After the impact of the credit crunch diminished the UK saw a fall in Libor rates, and bank rates came closer to base rates.

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(instant access saving rates starts Jan 2011.)

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How The Bank of England set interest rates

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Q. How does the Bank of England decide and set interest rates? The Bank of England set the repo rate. This is sometimes known as the ‘base rate’. It is the interest rate at which commercial banks (like Lloyds and Natwest) borrow from the Bank of England. The Bank of England can control liquidity and …

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Interest Rate Cycle

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The interest rate cycle is closely related to the economic or trade cycle. In theory, movements in interest rates should mirror the economic cycle. If the economy is growing strongly and inflationary pressures increasing – Central Banks will increase interest rates to slow down the economy and prevent inflation. If the economy enters into recession …

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Who benefits from low interest rates?

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When interest rates were cut to 0.5% in March 2009, few would have predicted that interest rates would have stayed low in UK, US and the Eurozone for so long. Interest rates have stayed at zero for several years – defying several predictions that they will rise soon. Who benefits from low-interest rates and who …

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Real interest rates

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The real interest rate is the nominal interest rate – inflation rate. For example, if the Bank of England set base rates of 5.5% and the CPI inflation rate is 3.4%. Then the real interest rates is said to be 2.1% A higher real interest rate is good for savers and bad for borrowers. Note, …

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