Saturday, August 9, 2008

What Happens When Interest Rates Increase? (Unit 3)

Monetary policy refers to policy instituted to influence the movement of AD by manipulating the level of money supply & interest rates

The interest rate decision is made by BOE’s Monetary Policy Committee which is made of 9 members. The MPC will conduct meeting every month & it’s a 2 days affair, where decision upon interest rate will be made in the second consecutive meeting at 12 noon.

The primary role of BOE is to set an interest rate that can enable the inflationary target of 2% to be met

Now in UK, the interest rates are 5% (July 2008) & the inflation rate is 3.8%. Therefore real interest rates are 1.2%

Since the inflation rate is at 10-year high, there is a possibility that the MPC will revise it upward in the coming meeting. So what is the impact?

(1) Consumption (C). An increase in base rate means an increase in the cost of borrowing. As such consumers will be less willing to borrow, say on buying houses, personal loans, credit cards etc. Also consumers with variable mortgages will have to incur higher monthly payment to banks resulting in lesser money left for consumption. Also, higher interest rates indicates that saving money is more interesting & the opportunity costs of using the money will increase. All this contributes to fall in C thus AD

(2) Investment (I). Similarly, firms will be deterred from taking loans to finance new projects or purchase capital goods. For some, it means lesser profits for reinvestment. Both contribute to fall in I thus AD

(3) Net exports (X-M). As interest rates increase, there will be large influx of foreign currency into UK coming from foreign fund managers & wealthy foreigners. This will result in surge in demand for pound. As pound appreciates, it means relatively more expensive to buy from UK thus a fall in exports. Meanwhile, for UK stronger pound translates into stronger purchasing power & this leads to increase in imports. Net effect will be fall in net exports. So AD falls too

Source: economicshelp

The combination of all these 3 will lead to a fall in AD, thus a fall in price level & economic growth {refer diagram above}.

However in reality, economy will still grow, but at a slower pace

Before arriving at any interest decision, MPC will at least consider the following factors:

(1) Level of unemployment in economy
(2) Current account & Balance of Payment as whole
(3) Present economic growth
(4) Earnings growth rate
(5) Personal credit figure
(6) Consumer & business confidence index
(7) Strength of pound
(8) Prices of house
(9) Level of firms’ investment
(10) Level of savings in economy

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