In this investigation I will set out to answer these two questions. How have interest rates changed over the last ten years? What affects have these changes had on the economy? I will answer these questions by comparing changes in interest rates to changes in economic variables like inflation, unemployment and exchange rates. I will then compare what the relationship should have been in theory to what really happened in real life. I will also show how economic growth has changed as the interest rates have changed, whether it has changed as economic theory dictates and if not why.
To show how it affects the economy I will look at inflation, economic growth or GDP, unemployment and use graphs to back up the economic theories.
The interest rate is a figure set by the central bank to try and stimulate or slow down the growth of the economy. The interest rate is the cost of saving and the cost of borrowing. I.e. when you take out a loan, it is the amount of money you have to pay back on top of your loan. If you save your money in a bank it is the amount of money that you gain during a certain time period. From this basic principal the government can control the money in the market; this is why it is called the monetary policy.
The monetary policy is the name of the policy, which deals in changing the interest rates. Monetary policy aims to influence the demand in the economy so that consumers demand as much as is produced. Interest rates are increased to moderate demand and inflation and are reduced to stimulate demand and increase output. If rates are too low then inflation may follow and it they are set too high then it reduces demand too much and this slows down inflation and reduces or removes economic growth.
The Monetary Policy Committee (MPC) sets an interest rate for the Bank of England's own transactions; these may include loans to other banks. Changes in this official rate then affects the whole range of interest rates set by the banks. This is called the transmission mechanism and will affect overdrafts, mortgages and savings accounts. This change in the official rate will affect the price of bonds and shares. It then has a wider affect, changing the demand of both business's and consumers to buy products. This changes company profits so changing the employment levels.
Essentially the way that interest rates affect the economy is through the forces of supply and demand on the economy. When the MPC sets the interest rates they are controlling the demand in the economy. Demand then affects the economy. So the interest rates affects employment, inflation, money flow, the separate markets like housing markets, exchange rates which this can be shown in the balance of payments, current and capital account.
Aggregate Demand = Consumer expenditure + Investment + Government spending + Exports - Imports
Investment is one of the causes of a shift in aggregate demand. If aggregate demand increases then this may cause inflation. This is because more is demanded than is supplied so prices go up. Interest rates are set by the MPC to keep the balance between amount demanded and amount supplied.
As you can see from this graph you can see that there is distinct relationship between the base interest rates and the housing market. This is because high interest rates increase the cost of a mortgage and reduce the demand for types of housing. Conversely, a fall in interest rates should stimulate higher market demand and put downward pressure on house prices. This should increase consumption associated with house buying and the rise in prices will increase total housing wealth and make consumers more confident about their personal finance.
You can only see this when you take into account the time lapse between a change in interest rates and the change in house prices. Take 99 for example when the interest rates were lowered before and after you only see the difference properly in 2000 when house prices soared.
In 1998 you can see that both house price inflation and interest rates increase and decrease with the time gap. This is because before hand there had been a slump in house prices and the interest rates were changed to accommodate this, however they rose to steeply and the prices got higher and higher as the demand for houses increased, because mortgages were lower. When this happened the market had to be slowed down. This was done by making the mortgages higher and making buying a house less attractive. When this happened demand decreased and the prices then also decreased.
When there is a cut in the credit card interest and personal loan rates this will induce spending as the credit rates will be less and there will be less for people to pay back. This means that the producers of the product primary, secondary and tertiary will get more money. This encourages producers to increase production and investment increasing employment and the overall output of the economy.
When there is a cut in savings accounts interest rates, people are more inclined to spend their money as they can will not get as much money when they get interest on their money. This is because it affects the attractiveness of spending today or spending later. However if you increase interest rates then people will be more inclined to save as they can get more money back and can buy more later, thus slowing down economic growth. This not only affects the consumer but also the businesses as they will spend less on buying equipment i.e. investment.
Higher interest rated in banks can also affect the value of assets such as house and share prices. When the interest rates increase the people put more money into banks then into other options such as shares and property. When demand falls so do prices and then the people owning the assets are more likely to sell them.
A change in interest rates will affect how much money consumers and businesses have, their cash flow. For those consumers and firms who have saved money in banks where interest is paid on their money then an increase in interest rates will give them more money. However those who have invested financial institutions money in the form of a loan will have to pay more money back. These fluctuations will affect consumer expenditure, which in turn affects aggregate demand. So if aggregate demand falls then both prices and GDP falls. If less is demanded then firms will lay of workers causing unemployment. When this happens the Central Bank's MPC sets lower interest rates and the opposite happens. The MPC's job is to keep this in balance.
When there is a rise in interest rates relative to those in other countries, foreign investors will invest in Britain, as investors are attracted by high interest because they can get more money back. When more money flows into the country the exchange rate will tend to appreciate. Foreign investors judge when the interest rates will rise in Britain. If they think interest rates will be raised they invest and influence the exchange rate before there has been any change in interest rates.
However, the reverse can also be true. Sometimes as the MPC lowers interest rates, it will stimulate the exchange rates to appreciate. This is because if interest rates are lowered, then the demand in the economy rises. This means that businesses will start to grow and so investors may judge a lowering in interest rates to increase profit. In this way it becomes attractive for foreigners to invest. This will strengthen the exchange rate.
When the pound increases against other currencies, our exports become more expensive abroad, so exporters get less money. Also foreign goods become cheaper in Britain so British products are less desirable. Imports and Exports are factors of demand so when imports go up and exports go down demand within the British economy goes down. This causes a slow down in the economy, and unemployment.
The balance of payments is concerned with two different accounts. These are the current account and the capital account. The current account is a record of the visible and invisible exports and imports in Britain. If British companies import more products than they export then the current account is in deficit. In the same way if we buy more of our own goods than foreign imports we will have a surplus.
The capital account shows us the investment in and out of the country, It also shows us the speculation i.e. the oversees purchasing of £'s, stocks, shares etc. If we have more investment and speculation coming into the country then we will have a surplus. If we have less coming in to the country we have a deficit.
The balance of payments is affected by interest rates:
Firstly the interest rates can stimulate investment in the country. This is because if the rates of interest are raised then investors will get more of their money back when they invest in our banks and other companies. The change in interest rates can also change the exchange rate in the same way. More foreigners will invest and this will make the exchange rate appreciate. If the exchange rate appreciates it becomes more difficult for Britain to sell their goods abroad and in this country. This means that there will occur a deficit in the current account. So the interest rates will be lowered to stimulate the economy and the exchange rates will fall. The exchange rates fall because the supply of £'s to buy imports exceeds the demand for £'s to buy exports. The capital account will be in deficit because of low interest rates (reduces investment). But because we have depreciation of the exchange rate imports will then become dearer and exports become cheaper. This means we buy more of our goods and we have a current account surplus. In this way one of the current and capital accounts are always in surplus while the other is in deficit.
From this you can see that when you have a high interest rate you will have a high capital account but you will have a low current account. This is the situation in Britain at the moment.
This graph proves that the interest rates can affect the economic growth through supply and demand.
This chart shows the proper pattern that the theory suggests between inflation and GDP or output. This reason for this is as I explained earlier that interest rates directly control investment. Investment controls supply and demand. When interest rates goes down demand goes up and output goes up.
Below these two graphs show how interest rates can be linked to inflation thorough aggregate supply and demand.
Although this appears to show a correlation it is actually the wrong way round. This is because high interest rates should mean low inflation. This is because when you have high interest rates, it is less desirable to invest in firms. This is because the money you have to pay back is greater with the higher interest rates. Because this is totally wrong I decided to try another chart.
In this chart I decided that I would calculate the real interest rate. That is the interest rate minus inflation. This is because if you save money for a whole year you get more money because of high interest rates but inflation means that the prices will go up at the same time. So interest rates minus inflation is how much money you actually gain in spending power when you save.
When I plotted real interest rates against inflation this shows the proper pattern. The pattern is that as interest rates goes up inflation goes down. This shows that the main control of inflation is interest rates and that the monetary policy is essential to keeping the balance between supply and demand. If the demand gets too high then inflation is caused and interest rates are used to bring demand down and discourage spending and investment.
This graph shows that economic growth does create jobs. Because economic growth is related to interest rates it gives backing to the economic theory of supply and demand.
From this graph you can see that there is a definite link between employment and economic growth. This is that as the GDP increases although not on the same level all the time employment increases as well. This is obvious because when economic growth increases firms are producing more so therefore there are more jobs. This is linked back to interest rates because of the supply and demand model that I explained earlier. On this graph there's one large exception during the boom years of 1988 to 91. During the years 88 too 93 the levels of employment rose at a much higher rate than the GDP. This is where the boom bust economic cycle did not create true employment, because GDP did not increase with the increase in employment.
This graph shows how interest rates are linked to unemployment. However this link is not very strong as you can see from this graph. The peaks and troughs do not always follow each other. This is because there is so many other economic variables that effect unemployment.
Model showering supply and demand that links interest rates and unemployment through GDP.
The link between interest rates and unemployment is aggregate demand and the growth of businesses. In 1980 there is a steep fall in the interest rate this is followed later on by a steep fall in the unemployment rates. The gap shows you that the effect takes 2 years to have an affect on the unemployment. Then as the interest rates increase in 1988 so does two years later the unemployment. In 1990 the base rates fall so does two years later the unemployment. This proves that there is a link between interest rates and aggregate demand. This is because this is the easiest way to change employment levels, GDP and inflation at the same time.
When you control interest rates you can also help to reduce unemployment as inflation and unemployment are related, the Phillips curve. The policy maker who controls aggregate demand can choose a combination of inflation and unemployment that best suits the country at that time.
Although this graph does not show a definite pattern it does give some backing to the Phillips curve. That is that when you have high inflation you have low unemployment. This is clearly seen in 1975 when the inflation is at 25 but the unemployment is as low as it gets. This clearly shows that there is a connection between the two indicators. However it is not all that distinct. This is because there are many other variables that affect unemployment.
This graph shows when the Phillip's curve affect is true since 1975. This is when there is a straight line going from high inflation and low unemployment to low inflation and high unemployment or the other way round. However when it is not like that it is displaying a pattern that does not agree with the Phillip's curve. Over the last 8 years it has not been in keeping with the Phillips curve and inflation has stayed the same while unemployment goes down. The Phillips curve affect is a sign of wage inflation rather than demand pull inflation. However, this does not matter because when wages are rising quickly, so are prices. So this means that over the last 8 years workers wages have been staying within the costs of production and the companies' have not needed to increase their prices to cover the costs of production and still gain profit.
As a general sum up of all these affects, if you increase the interest rates, then you slow down the economy. If you decrease the interest rates you speed up the economy. This power can be use to control the affects of the boom bust cycle in both the economy and in separate industries, e.g. housing. It can also affect inflation and can be used to keep inflation in check. Changes in interest rates take time to affect the economy, as they change demand and eventually inflation over a period of time. So interest rates have to be changed with an eye to the future and the level of inflation in a year's time.
The interest rate transmission can affect everything as changes in production can in turn lead to changes in employment. This is because people demand less so we produce less and need fewer workers.
However the monetary policy cannot be used by itself to make a stable economy because it does not always work properly and effectively. It has to be used with other policies that help to complete the four macroeconomic objectives. These four objectives are low inflation, high employment, steady economic growth and balance of payments equilibrium. From my investigation you can see that monetary policy can be used to affect all these things however together with, fiscal policy, exchange rate policy and supply side policy the economy can be kept stable.
There is a draw back with all the policies except the supply side policy, they all use demand to change their economic growth. This is because government spending and consumer expenditure are changed by fiscal policy and our imports and exports are changed by the exchange rate policy. All these things are in the aggregate demand formula.
If you use demand to control your economy you end up with a large problem and this problem is inflation. This can be seen on the aggregate demand diagram.
The LM curve is controlled by how much money there is in circulation, which is controlled by the central bank issuing and selling, bonds. When they change the amount of bonds they issue the money goes in or out of the system. If you decrease the amount of money in the system then you cause a contraction of the LM curve. When you put this into the IS-LM model you can see how this changes the interest rate. If you increase the money in circulation then you get an expansion, this can also be shown on the IS-LM curve.
This model shows that as you increase the money supply LM, the interest rates fall and the income and output increase.
This model shows the opposite of the last one because as you decrease the money supply, LM through buying bonds the interest rate goes up the income goes down and you slow down the economy.
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