Last Updated 23 Jun 2020

How Does an Increase Interest Rate Affect the Economy in the UK

Category Banking, Money, Trade
Words 1281 (5 pages)
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1.0 Introduction “Interest rate is the price paid by a borrower to a lender, usually on the basis of X percent of the capital per annum” (Gilpin, 1970, p.134). The interest rates in the UK are always set by the Bank of England which is the Central Bank in the UK. The Central Bank also operates monetary policy to ensure stability. The interest rate as part of monetary policy, in order to keep the inflation low and keep the economic growth stable and high over a sustained period of time (INTO Foundation booklet, 2008). However, in current years, the interest rate is very low in the UK. As a result of the financial crisis which stocked in 2008 in the USA, the economic in the UK has also been affected deeply. The UK’s interest rate now is 0.5%, it falls to the lowest for half a century (Boulden, 2009).

This essay discusses how interest rates affect the UK’s economy. I will describe how interest rates work in the current economic situation. The interest rates contribute to the economic growth in the UK.

2.0 How does an increase interest rate affect the economy in UK? 2.1Encourage people saving money and reduce borrowing First, a increasing interest rate will increase people saving money and reduce household borrowing (INTO Foundation booklet, 2008, p. 11). Because when interest rates rise, borrowing money from a bank becomes more expensive. It means that interest payments on credit cards and loans are becoming more expensive. Thus people will shop less and save money. For example, if a family is going to buy a new house, they need to borrow money from the bank to pay for the house. They plan to pay back the money in 10 years. At the same time, they must also pay the interest charged by the bank. As the interest rates rise, they will need to pay more. So people will choose to save money and not buy the house. Moreover, some people already have loans to pay for, and therefore they need to pay more interest to the bank. Thus they will have less income to buy other consumer goods. So when the interest rates rise, it will reduce consumption.

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2.2 Decrease firms to investment Similarly, if the interest rates rise, it would decrease firms to investment (INTO Foundation booklet, 2008, p. 11). For the same reason, when a company owner decides to expend their scale of the company, he needs a huge capital to invest. Most of them will choose to borrow money from a bank. When there is high interest rate, they will cancel borrowing money from the bank. So increasing interest rates will also lead to less investment.

2.3 Promoting the exchange rate and makes exports less An increase in interest rates is also promoting the exchange rate, and this makes exports less (INTO Foundation booklet, 2008, p. 11). The definition is, “An exchange rate is the rate at which one currency trades for another on the foreign exchange market” (Sloman, 2007, p. 441). The higher interest rate leads to hot money flows, because it encourages people to save money in the UK. For this reason, the exchange rates will rise. When the exchange rate rise, it causes exports to become more expensive and imports cheaper. On condition that the demand for exports and imports is elastic demand, ultimately the high exchange rate will help to reduce the Aggregate Demand and the inflation (Economics Essays, n.d.). During the past year the exchange rate has been very high in the UK. Some experts believe that the exchange rate in the UK is over estimated. Consequently, exports will become less and less.

2.4 Reduce the aggregate demand and inflation rate The next is increasing interest rates will also reduce the Aggregate Demand and inflation rate (INTO Foundation booklet, 2008, p. 11). The above three points have the deflationary effect on Aggregate Demand. That is because the Aggregate Demand includes consumption, investment, government spending and net exports (Sloman, 2007, p.238). Net exports means exports minus imports (INTO Foundation booklet, 2008, p.4). Therefore, when the consumption, investment and exports all fall, the Aggregate Demand will decrease too. Furthermore, when the interest rates rise the inflation rate will fall too. For example, Figure1 shows the interest rates and inflation rates from 1985 to 2003 in the UK (Begg, 2003, p. 177). In 1990, the inflation in UK was very high, so the Bank of England increased the interest rates. After that, the inflation falls. So the interest rates rise will help to reduce inflation rate.

2.5 The price and cost will fall The price and cost will fall (INTO Foundation booklet, 2008, p. 11). Because the interest rates rise, the investment and consumption decrease then the aggregate demand curve move to leftward. Table 1 shows when the aggregate demand decrease, the price level fall.

2.6 Increase in unemployment Finally, when the interest rates rise in the UK, it will increase unemployment rate. As the increase interest rates help to reduce the inflation rate, the low inflation will result in unemployment. For example, a firm wants to spend more on capital goods to extend their scale. So the firm owner needs money to invest. However, when the interest rates rise, the firm will have to cancel the plan. Assuming the firm invests it and extend their company, there will be a new factory then it will provide more jobs for people. However, if the company cancel the plan, it will make a lot of people lose their job. Therefore, interest rates rise will cause unemployment rate to rise, too.

3.0Evaluation 3.1Control the economy growth stable Therefore the interest rates will have a good impact on the aggregate demand which help to get balance. The increased interest rates can also help to control the real estate market. Because when interest rates rise, it becomes more expensive when people want to borrow money from a bank to buy a house. Therefore, less people are going to buy a house. Then the price of houses in the real estate market will get stable, and it will not increase significantly. So this can help to keep the UK’s economy stable and healthy.

3.2Policy conflicts, unemployment However, “there will almost be policy conflicts. Lower inflation is likely to come about at the expense of lower short term growth and higher unemployment” (INTO Foundation booklet, 2008, p.11). For example, Figure 2 shows the inflation rate and unemployment rate from 1985 to 2003 in the UK (Sloman, 2007, p. 310). The figure 1 shows when the interest rates rise, the inflation rate fall. So in figure 2 which from 1991 to 1998, there was a lower inflation and a higher unemployment. From 1985 to 1988, there was a lower inflation and a higher unemployment, too. Therefore, when the interest rates rise to keep the inflation rate stable, it will make the unemployment rate increase. So there still has a policy conflicts here.

4.0 Conclusion To conclude, the interest rates can help with the government to keep the economy growth healthy. However, there are still some conflicts. When the interest rise, it will encourage people put money in the bank, then they can get the high interest. It will also decrease the investment and keep the real estate market grows stable. It will push up the exchange rate and help to reduce the high inflation rate. Then the unemployment will increase, too. Most of the affects which from a increasing interest rate can help government to control the economic growth in the UK. However, the unemployment is still a problem. So I think the government and the bank of England need to produce other methods to help with the interest rates and the unemployment problem.

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