A useful tool for students is the idea of an ‘economist toolkit’. This is essentially a few key ideas that can be used to help answer different questions.
Let us consider a question. – Discuss the impact of an increase in interest rates?
This question is quite open-ended. First of all, consider the impact on:
- Aggregate Demand
- Aggregate Supply
- And suitable AD/AS diagram
Increased interest rates cause a fall in AD.
Then consider how an increase in interest rates affects the main objectives of government:
- Economic growth
- Low Inflation
- Low Unemployment
- Low current account deficit/surplus
- Stable Exchange Rate
- Government borrowing
For example, an increase in interest rates will tend to cause lower growth, lower inflation and higher unemployment. Higher interest rates will tend to cause an appreciation in the exchange rate. If unemployment increases government borrowing may worsen.
The next part of the answer is to evaluate the impact. This is to consider different points of view and the significance of any likely impact. When considering potential points for evaluation, you can always consider:
- Time Lags.
- Other components of AD
- State of the economy
- How significant is a factor?
- Different economic views e.g. Monetarist v Keynesian.
- Supply-side effects.
- Time lag. The impact of an increase in interest rates may take time. For example, if the Bank of England increases the base rate, it will not affect people on fixed rate mortgages. However, when they re-mortgage in a couple of years time, they will face higher interest rates. It takes roughly 18 months for changes in interest rates to have a full effect.
- Other components of AD. An increase in interest rates should reduce AD, however, if there is strong global demand for UK exports, then AD may not fall and the economy continues to grow.
- The State of Economy. E.g. in recession, an increase in interest rates would reduce spending considerably, in a boom people may be confident just to pay more for borrowing.
The Impact of an increase in interest rates depends on where the economy is. Consider this diagram.
- How significant is a factor? In UK interest rates are very significant because people with variable mortgages pay a large % of income on mortgage repayments.
- Supply Side Impacts. Higher interest rates will also reduce investment. If interest rates remain high for a considerable time then it will lead to lower investment and this may cause lower productivity growth in the economy.
For more details see: Essay on impact of Increase in interest rates
If the question was different, e.g. Discuss the impact of an increase in government spending.
You could also use a similar tool kit.
- Discuss impact on AD and AS
- Discuss impact on macro economic objectives
- Use same evaluation tool kit.
- Time lag
- Depends on other components of AD
- Depends on state of economy
- How significant the factor will be.
- Different views, e.g classical economists will be more sceptical of higher government spending.
- Supply side effect of higher government spending (e.g. depends what they spend money on)