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Ques 4 B
Ques 4 B
levels?
1 July 2018 by Tejvan Pettinger
Interest rates determine the amount of interest payments that savers will receive on their deposits.
An increase in interest rates will make saving more attractive and should encourage saving.
A cut in interest rates will reduce the rewards of saving and will tend to discourage saving.
However, in the real world, it is more complicated. The link between interest rates and saving is not clear
because many factors affect saving.
In 2009, the household saving ratio increased from 0.5% to over 8% – despite a cut in interest rates from 5 to
0.5%. This was because the impact of the recession encouraged saving. The fear of unemployment and
recession was greater than the effect of lower interest rates
Income and substitution effect of higher interest rates.
If interest rates fall, the reward from saving falls. It becomes relatively more attractive to hold cash
and/or spend. This is the substitution effect – with lower interest rates, consumers substitute saving for
spending.
However, if interest rates fall, savers see a decline in income because they receive lower income
payments. A pensioner relying on interest payments from saving may feel he needs to save more to
maintain their target income from savings.
Usually, the substitution effect dominates. Lower interest rates make saving less attractive. But, for some, the
income effect may dominate, and people may respond to lower interest rates by saving more to maintain their
standard of living.
Alternatively, a lower interest rate may encourage other forms of saving and investment. With very low bank
rates, it has encouraged people to look for better yields in the stock market. This is one reason why the stock
market did well in the great recession of 2008-2013 – savers have been buying shares to get a better rate of
interest rate than they can in a bank and on bonds.
It is also important to consider interest rates relative to other countries. If UK rates fall, but are still
higher than other major economies, this could lead to an inflow of hot money as investors take
advantage of the relatively higher interest rates. If UK rates are lower than Europe, some investors may
move their money out of the UK and into European banks.
Confidence in the exchange rate is also important. If the Pound is deemed, a ‘safe haven’ currency.
(e.g. during Euro crisis of 2011), this could cause higher demand for Sterling deposits.
Real interest rates
Real interest rates measure the interest rate – inflation rate. If interest rates are 5%, and inflation 3%, the real
interest rate is 2%. Savers are increasing their real wealth. However, if we have negative interest rates, (interest
rates of 0.5% and inflation of 3%), then savers will see a fall in the real value of their savings.
Confidence. A big factor is economic confidence. If households are pessimistic about the economic
outlook, they will tend to save more and concentrate on paying off their debts. For example, in 2007, we
have falling house prices and rising unemployment. Both of these factors reduce spending and
encourage saving.
Financial conditions. In the aftermath of the credit crunch, credit was hard to get. Therefore, borrowing
fell, and people concentrated on saving.
Wealth. People’s saving is often tied up in assets, such as houses. The housing market has a big
impact on saving in the UK. Rising house prices encourage equity withdrawal and higher spending.
Falling house prices have the opposite effect.
Real wage growth (nominal wages-inflation) a period of negative real wage growth (2009-17) saw a fall
in the savings ratio as consumers maintained spending by borrowing and eating into their savings.
Interest rates and exchange rate
Higher interest rates also make it more attractive to save money in the UK, as opposed to other countries.
Therefore, higher rates will cause ‘hot money flows’ and may cause the value of the £ to rise.
Interest rates determine the amount of interest payments that savers will receive on their deposits.
An increase in interest rates will make saving more attractive and should encourage saving.
A cut in interest rates will reduce the rewards of saving and will tend to discourage saving.
Example of interest rate changes
£20,000 Loan at an interest rate of 7%
Annual interest rate payment will be 0.07 * 20,000 = £1,400
If interest rates rise to 9%
Annual interest rate payment will rise to 0.09 * 20,000 = £1,800
The rise in interest rates will cost households an extra £400 a year. This will discourage borrowing.
Example of saving rate changes
£7,000 savings at 4%.
Annual interest payments received will be 0.04 * 7,000 = £280
How do interest rates affect savers and
If interest rates rise to 6%
saving levels?
1 July 2018 by Tejvan Pettinger
Interest rates determine the amount of interest payments that savers will receive on their deposits.
An increase in interest rates will make saving more attractive and should encourage saving.
A cut in interest rates will reduce the rewards of saving and will tend to discourage saving.
However, in the real world, it is more complicated. The link between interest rates and saving is not clear
because many factors affect saving.
In 2009, the household saving ratio increased from 0.5% to over 8% – despite a cut in interest rates from 5 to
0.5%. This was because the impact of the recession encouraged saving. The fear of unemployment and
recession was greater than the effect of lower interest rates
Income and substitution effect of higher interest rates.
If interest rates fall, the reward from saving falls. It becomes relatively more attractive to hold cash
and/or spend. This is the substitution effect – with lower interest rates, consumers substitute saving for
spending.
However, if interest rates fall, savers see a decline in income because they receive lower income
payments. A pensioner relying on interest payments from saving may feel he needs to save more to
maintain their target income from savings.
Usually, the substitution effect dominates. Lower interest rates make saving less attractive. But, for some, the
income effect may dominate, and people may respond to lower interest rates by saving more to maintain their
standard of living.
Alternatively, a lower interest rate may encourage other forms of saving and investment. With very low bank
rates, it has encouraged people to look for better yields in the stock market. This is one reason why the stock
market did well in the great recession of 2008-2013 – savers have been buying shares to get a better rate of
interest rate than they can in a bank and on bonds.
It is also important to consider interest rates relative to other countries. If UK rates fall, but are still
higher than other major economies, this could lead to an inflow of hot money as investors take
advantage of the relatively higher interest rates. If UK rates are lower than Europe, some investors may
move their money out of the UK and into European banks.
Confidence in the exchange rate is also important. If the Pound is deemed, a ‘safe haven’ currency.
(e.g. during Euro crisis of 2011), this could cause higher demand for Sterling deposits.
Real interest rates
Real interest rates measure the interest rate – inflation rate. If interest rates are 5%, and inflation 3%, the real
interest rate is 2%. Savers are increasing their real wealth. However, if we have negative interest rates, (interest
rates of 0.5% and inflation of 3%), then savers will see a fall in the real value of their savings.
Confidence. A big factor is economic confidence. If households are pessimistic about the economic
outlook, they will tend to save more and concentrate on paying off their debts. For example, in 2007, we
have falling house prices and rising unemployment. Both of these factors reduce spending and
encourage saving.
Financial conditions. In the aftermath of the credit crunch, credit was hard to get. Therefore, borrowing
fell, and people concentrated on saving.
Wealth. People’s saving is often tied up in assets, such as houses. The housing market has a big
impact on saving in the UK. Rising house prices encourage equity withdrawal and higher spending.
Falling house prices have the opposite effect.
Real wage growth (nominal wages-inflation) a period of negative real wage growth (2009-17) saw a fall
in the savings ratio as consumers maintained spending by borrowing and eating into their savings.
Interest rates and exchange rate
Higher interest rates also make it more attractive to save money in the UK, as opposed to other countries.
Therefore, higher rates will cause ‘hot money flows’ and may cause the value of the £ to rise.
Interest rates determine the amount of interest payments that savers will receive on their deposits.
An increase in interest rates will make saving more attractive and should encourage saving.
A cut in interest rates will reduce the rewards of saving and will tend to discourage saving.
Example of interest rate changes
£20,000 Loan at an interest rate of 7%
Annual interest rate payment will be 0.07 * 20,000 = £1,400
If interest rates rise to 9%
Annual interest rate payment will rise to 0.09 * 20,000 = £1,800
The rise in interest rates will cost households an extra £400 a year. This will discourage borrowing.
Example of saving rate changes
£7,000 savings at 4%.
Annual interest payments received will be 0.04 * 7,000 = £280
If interest rates rise to 6%
Annual interest payments received will be 0.06 * 7,000 = £420
The saver gains an extra £149 a year
Related
Annual interest payments received will be 0.06 * 7,000 = £420
The saver gains an extra £149 a year
Related