Definition: Interest rates or the cost of borrowing or a reward for saving
In the United Kingdom, the Bank of England utilise the monetary policy influence interest rates and control the level of inflation. Their main objective is to keep inflation at the 2% target.
When interest rates rise:
Households:
Borrowing becomes more expensive –> Loans and mortgages become more expensive –> Decrease in consumption –> Savings increased –> Aggregate demand decreases.
Firms:
Cost of borrowing increases –> Investment decreases –> Aggregate demand decreases
Exchange rate:
The demand for the pound increases and the value of the pound appreciates. This makes having UK financial assets more attractive.
Overall:
Decrease in economic growth and an increase in cyclical unemployment.
When interest rates fall:
Households:
Borrowing becomes cheaper –> Consumption and investment increases –> Aggregate demand increases –> Increase in economic growth and potentially there may be a decrease in unemployment.
Exchange rate:
The demand for the pound decreases and the pound depreciates in value.
Overall:
Increase in economic growth and decrease in unemployment.
Evaluation Points:
Time lags – It can take a while for a change in interest rates to fully affect economy.
Consumer confidence – If consumers are worried about the economy, they may choose to save rather than spend, even when interest rates fall.
Business confidence – Lower interest rates don’t guarantee higher investment if firms are uncertain about future demand.
Elasticity – The impact depends how sensitive firms and households are to the change interest rates.
Supply-side inflation – Higher interest rates normally are more effective against demand-pull inflation than inflation caused by supply side shocks such as energy shock due to a hurricane.