Question

Please discuss the impacts of interest rate change on the economy and business firms.

Answer 1

Credit is borrowed money. Many small firms depend on credit such as bank loans and overdrafts to help finance their business activities.

Interest is the reward for lending and the cost of borrowing. The interest rate is the percentage rate charged on a loan or paid on savings. For example, an annual interest rate of 5% means £5 is paid in interest for every £100 saved or borrowed.

An increase in interest rates can affect a business in two ways:

Customers with debts have less income to spend because they are paying more interest to lenders. Sales fall as a result.

Firms with overdrafts will have higher costs because they must now pay more interest.

The impact of a change in interest rates varies from business to business. Firms that make luxury goods are hit hardest when interest rates rise. This is because most customers cut back on non-essentials when their incomes fall as a result of interest rate rises.

The Central Bank usually increase interest rates when inflation is predicted to rise above their inflation target. Higher interest rates tend to moderate economic growth. Higher interest rates increase the cost of borrowing, reduce disposable income and therefore limit the growth in consumer spending. Higher interest rates tend to reduce inflationary pressures and cause an appreciation in the exchange rate.

Higher interest rates have various economic effects:

Increases the cost of borrowing. With higher interest rates, interest payments on credit cards and loans are more expensive. Therefore this discourages people from borrowing and spending. People who already have loans will have less disposable income because they spend more on interest payments. Therefore other areas of consumption will fall.

Increase in mortgage interest payments. Related to the first point is the fact that interest payments on variable mortgages will increase. This will have a significant impact on consumer spending. This is because a 0. 5% increase in interest rates can increase the cost of a £100,000 mortgage by £60 per month. This is a significant impact on personal discretionary income.

Increased incentive to save rather than spend. Higher interest rates make it more attractive to save in a deposit account because of the interest gained.

Higher interest rates increase the value of a currency (Due to hot money flows, investors are more likely to save in British banks if UK rates are higher than other countries) A stronger Pound makes UK exports less competitive – reducing exports and increasing imports. This has the effect of reducing aggregate demand in the economy.

Rising interest rates affect both consumers and firms. Therefore the economy is likely to experience falls in consumption and investment.

Government debt interest payments increase. The UK currently pays over £30bn a year on its national debt. Higher interest rates increase the cost of government interest payments. This could lead to higher taxes in the future.

Reduced confidence. Interest rates affect consumer and business confidence. A rise in interest rates discourages investment; it makes firms and consumers less willing to take out risky investments and purchases.

Lower interest rates make it cheaper to borrow. This tends to encourage spending and investment. This leads to higher aggregate demand (AD) and economic growth. This increase in AD may also cause inflationary pressures.

In theory, lower interest rates will:

Reduce the incentive to save. Lower interest rates give a smaller return from saving. This lower incentive to save will encourage consumers to spend rather than hold onto money.

Cheaper borrowing costs. Lower interest rates make the cost of borrowing cheaper. It will encourage consumers and firms to take out loans to finance greater spending and investment.

Lower mortgage interest payments. A fall in interest rates will reduce the monthly cost of mortgage repayments. This will leave householders with more disposable income and should cause a rise in consumer spending.

Rising asset prices. Lower interest rates make it more attractive to buy assets such as housing. This will cause a rise in house prices and therefore rise in wealth. Increased wealth will also encourage consumer spending as confidence will be higher. (wealth effect)

Depreciation in the exchange rate. If the UK reduce interest rates, it makes it relatively less attractive to save money in the UK (you would get a better rate of return in another country). Therefore there will be less demand for the Pound Sterling causing a fall in its value. A fall in the exchange rate makes UK exports more competitive and imports more expensive. This also helps to increase aggregate demand.

Overall, lower interest rates should cause a rise in Aggregate Demand (AD) = C + I + G + X – M. Lower interest rates help increase (C), (I) and (X-M)