Why have we just lowered the interest rates?

Mark Careny has just officially lowered interest rates from 0.5% to 0.25 %. Why did we do this and what will be the impact?

This article is very much economics 101, explaining it to people who don’t have as much economic knowledge so if you’re looking for some incredible commentary that will blow your socks off at a degree level, I regret to inform you that you are in the wrong place.

Background information

AD & AS:

Firstly,we should remember that economics consists of demand and supply. For a quick overview of demand and supply and the diagrams, I would suggest skimming through this link in order to gain a basic understanding. In macroeconomics (economics concerning the whole country), we can transfer these ideas to a bigger level of aggregrate demand (AD) and aggregate supply (AS). AD & AS are what essentially determine the level of output and prices in the economy.

ASAD2

Aggregate Supply: This consists of suppliers to our economy, namely factors of production. Essentially this is capital, labour and land. If the cost of capital falls, then there will be a greater supply as people will be willing to supply more.

Aggregate Demand: This is made of four factors:

  • Consumption: What we spend money on e.g. clothes and food
  • Investment: Capital bought in the long term.
  • Government Spending: Government spending-Tax
  • Net Exports: Exports-Imports

This is essentially the demand for goods and services from our economy

The actual meat

Our Economy at current

With this information, we can start to look at the effects of interest rates on the economy. However, before that we should look at our economy at current.

To be blunt it is probable that with no intervention there will be a recession as a direct result of Britains choice to leave the European Union. (Yes Brexiteers, you may not like me saying it and are welcome to accuse me of scaremongering, but the stats don’t lie). This is because investors have little confidence and so do consumers. This is evident with the poor recent purchasing managers index and with many other indicators. People, home and abroad, have little faith and no knowledge of the shape of our economy in the future.

With a stagnating economy, in order to prevent, or lessen the impact of a recession, the Bank of England need to use monetary policy. This was voted for by the nine man team in the Bank of England known as the Monetary Policy Committee (MPC) and announced by Mark Carney

Carney
The main man in the bank of England

What is an interest rate?

The interest rate is the cost of a loan or the reward from saving. If I borrow £1000 at a 0.5% interest rate, I am expected to pay back £1005 in the year, while if the interest rate falls to 0.25%, I am expected to pay back £1002.50. While this may not seem like much, if I, as an investor, had invested £1000000, the difference would be much more significant.

Lowering the interest rates

At this point I do not know the interest rates (I wrote this piece in apprehension), but I believe that they are now down to the historically low 0.25%. This is in order to boost aggregate demand in the economy. But how?

ADUp.png
An interest rate cut leads to an increase in aggregate demand from AD to AD*. Output increases from Y to Y’. Price levels increase from P to P’.

Investors: If the cost of borrowing is reduced, investors are more likely to want to borrow money invest money in new goods and capital. The increase in investment is reflected by the increase in (aggregate) demand.

Savers: The interest rate also reflects how much people get from their savings. A lower interest rate means that people will be less inclined to save as they get less reward. This leads to more people consuming and a resultant increase in demand.

People may decide to invest in assets, therefore the demand and price of them will increase, restoring confidence within the economy.

Exporters and Importers: As currency investors will not get as much of a return from a lower interest rate (when saving with the Sterling in English Banks), the demand for our currency will fall, therefore the price of it will fall. A weaker pound makes it cheaper to export, making British goods more competitive abroard. This means an increase in aggregate demand.

Import prices rise which makes domestic (made in Britain) goods more competitive here, boosting our consumption of domestic goods and therefore aggregate demand again.

These boosts in aggregate demand do lead to an increase in our output (GDP) as well as our price levels

Inflation as a result of interest rates being cut

As you can see in the diagram above, price levels also increase. This means higher inflation. In an economy, some inflation is good. The Bank of England targets a 2% inflation rate. At the moment ours is 0%, therefore some inflation would be welcome, as it gives people an incentive to spend their money before it becomes worth less. As we are going to see an economic downturn, inflation is unlikely to be too high anyway. Therefore high inflation should be of very little concern.

Other things to consider

  • Interest rate cuts take plenty of time to actually make a difference, so may not help avoid a recession.
  • The extent of an impact is different everytime. Consumer confidence and bank willingness to lend can vary the impact dramatically

-Swift Economist

 

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