What effects have interest rates had on economic indicators like GDP, Inflation ,Unemployment and Balance of Payments in the last ten years?

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Oliver Peck                                                                     GSCE Economics Coursework

What effects have interest rates had on economic indicators like GDP, Inflation ,Unemployment and Balance of Payments in the last ten years?

Introduction

In this investigation, I will set out to answer how interest rates have affected the main economic indicators such as GDP, Inflation, Unemployment and Balance of Payments over a period of ten years. I will begin by explaining the economic theory of how interest rates affect the economy and with the help of real economic data and graphs. I will attempt to evaluate how well the theory is working.

Economic theory can only be tested in the real world where there are some many variables. Unlike other sciences, economic theory cannot be tested under laboratory conditions.

Background Knowledge

What are Interest Rates?

Interest rates are the amounts which need to be paid in exchange for borrowing money. The interest rate is the cost of borrowing and the reward for saving i.e. when you take out a loan, the interest rate is the amount of money you have to pay back on top of your loan. If you save your money with a financial institution, the interest rate is the amount of money you gain during that period of time.

In the UK, the base interest rate is set by the MPC (Monetary Policy Committee), an independent committee which comprises of nine Bank of England officials and independent experts. The committee meets monthly to agree any change to interest rates and to set the base interest rate for the Bank of England’s own transactions; these may include loans to other banks.

The interest rate is a tool used to meet some of the Government’s economic objectives:

  • To achieve low and stable inflation
  •  Maintain high level of employment
  • Encourage economic growth.
  • Achieve a strong balance of payments

How do Interest Rates Work?

 Monetary Policy, decided by the MPC, uses changes in interest rates to control the demand for money. This in turn affects the aggregate level of demand in the economy so that national income is at a level that sustains the inflation target. Currently, the Government has set the inflation target at 2.5% CPI (Cost Price Index) (plus or minus 1%). If this rate diverges by more than 1% from this the MPC will then advice the Chancellor of the Exchequer on what should be done.

Interest rates are increased to moderate aggregate demand and inflation, and reduced to stimulate aggregate demand and increase output. If rates are too low, then inflation may follow, and if they are set too high then it reduces aggregate demand too much which slows down inflation but reduces economic growth and employment.

Monetary Policy always operates with a time lag and any effects of a change in interest rates can take up to 18 months to filter through the economy. The MPC issues a forecast of inflation every 3 months and is trying to control inflation levels in about 18 months time.

Changes in the official rate affects the whole range of interest rates set by the banks. This is called the transmission mechanism!

This is the transmission mechanism – or the economic route map between changing interest rates and inflation

 Source-  http://www.bankofengland.co.uk/education/targettwopointzero/economy/recap.htm#a1

Why does a change in interest rates affect the economy?

Essentially, the way that interest rates affect the economy is through the forces of aggregate supply and aggregate demand in the economy. When the MPC sets the interest rates they are controlling the demand in the economy which affects employment, inflation, money flow, the separate markets like housing markets, exchange rates which  can be shown in the balance of payments, current and capital account.

How Interest rates affect Aggregate Demand?

AD= C+I+G+(X-M)

OR

Aggregate Demand = Consumer expenditure + Investment + Government spending + (Exports- Imports)

Real output or Gross Domestic Product (GDP) = the total value of the output of goods and services in the economy.

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Aggregate demand- total demand for goods and services in the economy. It includes:

  • Consumer expenditure
  • Investment by firms in plant and machinery
  • Government spending
  • Exports- Imports

Consumer expenditure- which affects aggregate demand, can be influenced by interest rates. When interest rates are low, consumers and firms find it cheaper to borrow and as a result people spend more money. Also, with low interest rates there is less incentive to save as the reward is lower. When consumer expenditure rises, the overall increased demand helps create jobs and reduces unemployment. However, high interest rates ...

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