MONETARY POLICY (AS NOTES) Tutor 2u:

Effects of Changes in Interest Rates

There are several ways in which changes in interest rates influence aggregate demand. These are
collectively known as the transmission mechanism of monetary policy.
One of the principal channels that the MPC can use to influence aggregate demand, and therefore
inflation, is via the lending and borrowing rates charged by the market.
When the Banks base interest rate rises, banks will typically increase both the rates that they charge on
loans, and the interest that they offer on savings. This tends to discourage businesses from taking out
loans to finance investment and encourages the consumer to save rather than spend and so depresses
aggregate demand. Conversely, when the base rate falls, banks tend to cut the market rates offered on
loans and savings. This will tend to stimulate aggregate demand.
Changes to the level of interest rates take time to have an impact on overall economic activity - i.e.
there is a time lag involved. A change in interest rates can have wide-ranging effects on the economy.

The Banks view of the transmission mechanism resulting from a change in official base interest rates is
shown in the flow chart above the key to it is that short-term changes in interest rates feed through
fairly quickly to the rest of the UK financial system (e.g. resulting in changes in mortgage interest rates,
rates of interest on savings accounts and also credit card rates) and then start to influence the spending
and savings decisions of millions of households and businesses.
A key influence played by rate changes is the effect on confidence in particular households confidence
about their own personal financial circumstances.
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Housing market & house prices: Higher interest rates increase the cost of mortgages and
eventually reduce the demand for most types of housing. This will slow down the growth of
household wealth and put a squeeze on equity withdrawal (consumers borrowing off the back of
rising house prices) which adds directly to consumer spending and can fuel inflation
Effective disposable incomes of mortgage payers: If interest rates increase, the income of
homeowners who have variable-rate mortgages will fall leading to a decline in their effective
purchasing power. The effects of a rate change are greater when the level of existing mortgage
debt is high, leading to a rise in debt-servicing burdens for home-owners. On the other hand, a
rise in interest rates boosts the disposable income of people who have paid off their mortgage
and who have positive net savings in bank and building society accounts.
Consumer demand for credit: Higher interest rates increase the cost of servicing debt on credit
cards and should lead to a deceleration in the growth of retail sales and spending on consumer
durables. Much depends on the impact of a rate change on consumer confidence.
Business capital investment: Firms often take the actual and expected level of interest rates
into account when deciding whether or not to proceed with new capital investment spending. A
rise in short term rates may dampen business confidence and lead to a reduction in planned
capital investment. However, many factors influence investment decisions other than rate
changes.
Consumer and business confidence: The relationship between interest rates and business and
consumer confidence is complex, and depends crucially on prevailing economic conditions. For
example, when businesses and consumers are worried about the risk of a recession, an interest
rate cut can boost confidence (and therefore aggregate demand) because it reassures the public
that the Bank is alert to the dangers of an economic slump. There are circumstances, however,
where a cut in rates could undermine confidence. For example, were the Bank of England to cut
interest rates too quickly, the fear might be that the Bank is particularly worried about the
prospects of a recession. The setting of interest rates nearly always calls for a finely balanced
judgement, particularly when the effects on consumer and business confidence are concerned.
Interest rates and the exchange rate: Higher UK interest rates might lead to an appreciation of
the sterling exchange rate particularly if UK interest rates rise relative to those in the Euro Zone
and the United States attracting inflows of hot money into the British financial system. A
stronger exchange rate reduces the competitiveness of UK exports in overseas markets because it
makes our exports appear more expensive when priced in a foreign currency (leading to a decline
in export volumes and market share). It also reduces the sterling price of imported goods and
services leading to lower prices and rising import penetration. If the trade deficit in goods and
services widens, this is a net withdrawal of demand from the circular flow and acts to reduce
excess demand in the economy.

Usually a UK interest rate cut will tend to weaken the pound as it makes it less attractive for foreign
investors to hold their money in Britain.
When the pound rises, British exports become more expensive, while imported goods from abroad become
cheaper. So a rising pound leads to a fall in demand for UK exports and a fall in demand for domestically
produced goods that compete with imports from overseas. A rising pound therefore reduces aggregate
demand, and so can dampen down the rate of inflation. An increase in the pound also affects the inflation
rate directly by bringing down the price of imported goods.

Monetary Policy Asymmetry

Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are more
affected by interest rate changes than others (for example exporters and industries connected to the
housing market). And, some regions of the British economy are also more exposed (sensitive) to a change
in the direction of interest rates.
The markets that are most affected by changes in interest rates are those where demand is interest
elastic in other words, market demand responds elastically to a change in interest rates (or indirectly
through changes in the exchange rate).
Good examples of interest-sensitive industries include those directly linked to demand conditions in the
housing market exporters of manufactured goods, the construction industry and leisure services. In
contrast, the demand for basic foods and utilities is less affected by short term fluctuations in interest
rates.
The rate of interest is under the control of the Bank of England, but most other economic variables are
not! The MPCs decisions can influence consumer and business behaviour but it cannot determine directly
the rate of inflation.