Economics help blog – Page 78

Effect of lower interest rates

2 December 20193 August 2019 by Tejvan Pettinger

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)

UK interest rates

inflation-interest-rates

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

ad increase - inflation

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.

What are the economic functions of a government?

22 December 20193 August 2019 by Tejvan Pettinger

Readers question: What are the functions of government in a capitalist economy? In summary, the economic functions of a government include: Protection of private property and maintaining law and order / national defence. Raising taxes. Providing public services not provided in a free market (e.g. health care, education, street lighting) Limit market failure through the …

NHS spending cuts

10 December 20191 August 2019 by Tejvan Pettinger

To what extent has the UK seen cuts in spending to the NHS and health care spending in recent years? In short: Actual spending on the NHS has increased. Real spending per capita has been broadly flat in recent years. As a share of the nations wealth, it is falling and it is true to …

Basic questions of economics

10 March 202029 July 2019 by Tejvan Pettinger

The fundamental economic problem is one of scarcity. The basic questions of economics become: What to produce? How to produce? For whom to produce? You could also add When to produce? What to produce? Given limited resources of labour, raw materials and time, economic agents have to decide what to produce. Most primitive economies …

Impact of Expansionary Fiscal Policy

9 December 201925 July 2019 by Tejvan Pettinger

Definition of expansionary fiscal policy. This involves the government seeking to increase aggregate demand – through higher government spending and/or lower tax. Expansionary fiscal policy is usually financed by increased government borrowing – and selling bonds to the private sector. Keynes said expansionary fiscal policy should be used during a recession – when there is …

Monopoly diagram short run and long run

30 November 201924 July 2019 by Tejvan Pettinger

Readers Question: Explain with the help of diagrams the equilibrium of a firm having monopoly power in the market in the short-run and long-run? The diagram for a monopoly is generally considered to be the same in the short run as well as the long run. Profit maximisation occurs where MR=MC. Therefore the equilibrium is …

Inflation: advantages and disadvantages

10 March 202024 July 2019 by Tejvan Pettinger

Readers Question: what are the advantages and disadvantages of inflation? Inflation occurs when there is a sustained increase in the general price level. Traditionally high inflation rates are considered to be damaging to an economy. High inflation creates uncertainty and can wipe away the value of savings. However, most Central Banks target an inflation rate …

Pros and Cons of Mergers

30 November 201922 July 2019 by Tejvan Pettinger

A merger involves two firms combining to form one larger company; it can occur due to a takeover or mutual agreement.

The pros and cons in summary:

Advantages of mergers

Economies of scale – bigger firms more efficient
More profit enables more research and development.
Struggling firms can benefit from new management.

Disadvantages of mergers

Increased market share can lead to monopoly power and higher prices for consumers
A larger firm may experience diseconomies of scale – e.g. harder to communicate and coordinate.

pros-cons-mergers

When looking at mergers it is important to look at the subject on a case by case basis as each merger has different possible benefits and costs – depending on the industry and firms in question.

Pros of mergers

1. Network Economies. In some industries, firms need to provide a national network. This means there are very significant economies of scale. A national network may imply the most efficient number of firms in the industry is one. For example, when T-Mobile merged with Orange in the UK, they justified the merger on the grounds that:

“The ambition is to combine both the Orange and T-Mobile networks, cut out duplication, and create a single super-network. For customers, it will mean bigger network and better coverage, while reducing the number of stations and sites – which is good for cost reduction as well as being good for the environment.”

2. Research and development. In some industries, it is important to invest in research and development to discover new products/technology. A merger enables the firm to be more profitable and have greater funds for research and development. This is important in industries such as drug research, where a firm needs to be able to afford many failures.