Interest rates etc

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.

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Macro economic objectives and conflicts - read this link!

Conflicts of objectives and interest rates

The effect of raising interest rates

Interest rates and the economy

Interest rates

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.

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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.

Read more