Introduction
The base interest rate in the UK economy is set by the Bank of England. Each month, the Monetary Policy Committee of the Bank of England to decide what the base rate should be.
Since 2009 the base interest rate in the UK has been kept a historically low level of 0.5%.
The base interest rate set by the Bank of England affects other interest rates in the economy because it is the rate at which banks can themselves lend from the Bank of England.
In theory, a lower base rate will lead to lower interest rates on borrowings paid by businesses – but not necessarily.
The effect of a change in interest rate will be affected by whether borrowing is at a variable or fixed rate:
With a variable rate, the interest charged varies in relation to the base rate.
A fixed interest rate means that the interest cost is calculated at a fixed rate – which doesn't change over the period of the credit, whatever happens to the base rate.
Effects of Changes in Interest Rates
The effect of a change in interest rates will depend on several factors, such as:
- The amount that a business has borrowed and on what terms
- The cash balances that a business holds
- Whether the business operates in markets that depend on consumer spending
Let's look at the third factor listed above to examine the implications a little more closely.
Consider the example of households and consumers who like to pay for their goods and services using borrowing such as credit cards or a bank overdraft or loan. Also think about households who have substantial balances outstanding on a mortgage used to finance a house purchase.
An increase in interest rates will mean that the cost of borrowing rises.
