Monetary policy - the effect of interest rates

The Monetary Policy Transmission Mechanism

It is worth remembering that when the Bank of England is making an interest rate decision, there will be lots of other events and policy decisions being made elsewhere in the economy, for example changes in fiscal policy by the government, or perhaps a change in world oil prices or the exchange rate. In macroeconomics the ceteris paribus assumption (all other factors held equal) rarely applies!

• There are several ways in which changes in interest rates influence aggregate demand, output and prices. These are collectively known as the transmission mechanism of monetary policy
• One of the channels that the Monetary Policy Committee in the UK can use to influence aggregate demand, and inflation, is via the lending and borrowing rates charged in the financial markets.
• When the Bank's own base interest rate goes up, then commercial banks and building societies will typically increase how much they charge on loans and the interest that they offer on savings.
• This tends to discourage businesses from taking out loans to finance investment and encourages the consumer to save rather than spend — and so depresses aggregate demand
• Conversely, when the base rate falls, banks cut the market rates offered on loans and savings and the effect ought to be a stimulus to demand and output.

A key influence played by interest rate changes is the effect on confidence – in particular household's confidence about their own personal financial circumstances.

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Sources of finance

Sources of finance

Debt finance for business

Key Sources of Business Finance

Long-term	Medium-term	Short-term
Finances whole business over many years	Finances major projects or assets with a long-life	Finances day-to-day trading of the business
Examples:	Examples:	Examples:
Share capital Retained profits Venture capital Mortgages Long-term bank loans	Bank loans Leasing Hire purchase Government grants	Bank overdraft Trade creditors Short-term bank loans Factoring

What is Debt Finance?

Debt financing means borrowing money from an outside source with the promise of paying back the borrowed amount, plus the agreed-upon interest, at a later date

Main sources of debt finance are:

• Bank Loan
• Bank Overdraft
• Credit Card
• Mortgage
• Peer to Peer Lending
• Corporate Bond

Key Features of Bank Loans

• Loan provided over fixed period (e.g. 5 years)
• Rate of interest is either fixed or variable
• Timing and amount of loans repayments are set by the lender
• Usually some security required for the loan - lowers the risk
• Unsecured loans pay higher interest rate because of risk
• Non-performing loans occur when the borrower is unable to repay some or all of the debt

Benefits and Disadvantages of Bank Loans

Benefits

• Greater certainty of funding, provided terms of loan complied with
• Lower interest rate than a bank overdraft
• Appropriate method of financing fixed assets

Drawbacks

• Requires security (collateral)
• Interest paid on full amount outstanding
• Harder to arrange
• Startups and small businesses often excluded

Bank Overdrafts

• Short-term finance, widely used by businesses of all sizes
• An overdraft is really a short-term facility – the bank lets the business “owe it money” when the bank balance goes below zero
• A flexible source of finance: only used when needed
• Excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time)

Benefits and Disadvantages of Bank Overdrafts

Benefits

1. Relatively easy to arrange
2. Flexible – use as cash flow requires
3. Interest – only paid on the amount borrowed under the facility

Drawbacks

1. Can be withdrawn at short notice
2. Interest charge varies with changes in interest rate
3. Higher interest rate than a bank loan

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Raising finance

Raising Finance for an Established Business from tutor2u