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 make borrowing expensive and consumers borrow less. If consumers borrow less money, they will have less money to spend and aggregate demand will fall.
Investment- at times of low interest rates, firms invest in machinery and other equipment, buildings etc and this increased investment creates economic growth as the economy is able to produce more output in total- GDP goes up! Similarly, when interest rates are high, firms invest less.
Government Spending- Tax changes affect disposable incomes and therefore consumption and investment. Any changes in Government spending directly changes the level of aggregate demand.
Net effect of International Trade (Exports- Imports)- Interest rates affect imports and exports by affecting the exchange rate of an economy. When interest rates rise it stimulates foreign investment, therefore, it increases the demand for the pound and this in turn causes the pound to appreciate. When the pound increases against other currencies, our exports become more expensive abroad, so it will not sell as much. Also foreign goods become relatively cheaper making British products are less desirable. The opposite happens when interest rates decrease.
How Interest Rates affect Economic indicators.
Gross Domestic Product- GDP
GDP is the value of everything produced in the economy in the year. High and sustainable economic growth is possibly the most important of all Government objectives. Economic growth leads to improved standards of living which are very positive for any inhabitants of an economy. Interest rates directly affect the amount individuals and businesses want to borrow. When interest rates are low firms invest in machinery, equipment, buildings etc and this direct investment leads to economic growth i.e. GDP goes up. High interest rates have the opposite effect and this has a significant affect on the level of aggregate demand. As investment increases so does aggregate demand and as investment decreases then aggregate demand decreases- all things being equal in the formula.
Graph to show Interest Rate Change and GDP Growth in the United Kingdom
From the graph, interest rates began at 5.21% at the start of the ten year period and steadily increased to about 5.80% in the second quarter in 1995. In 1998 it reached a high of 7.3%. But from about 1999 onwards interest rates decreased steadily until they reached lowest point at 3.50% in 2003
GDP growth rates over the same period have been far more stable. A high of 2.32 in period 1 of 1997 and a low of 0.27 in the third quarter of 2001. The trend has been much more stable but with a slight fall over the ten year period.
I have already established that high interest rates can restrict growth via reduced consumer spending and investment. Nonetheless, over the last ten years the level at which interest rates have been set has maintained a steady growth without inflation or recession.
(Using data from , I plotted this data which allows us to see the relationship between GDP and interest rates.)
These two separate graphs show clearly how these two variables of GDP and interest rates affect each other. They show an inverse relationship between the two. As interest rates fall, GDP increases and vice versa. For example, from 1998 to 1999 there was a good sharp decrease in interest rates which led to a good sharp increase of GDP in 2000. However, it is important to remember that changes in interest rates operate with a time lag and the full effects of any change in interest rates may take up to two years to work their way through the economy.
The effects of the interest rate rise from 1999 - 2000 was not felt until 2001- 2002 where GDP decreased. This relationship relates directly to the theory that as interest rates increase then GDP decreases. And if interest rates decrease then GDP increases, as there is more investment by firms and spending by consumers.
I believe that monetary policy over the last few years, using interest rates as a tool, has been successful in maintaining steady growth in the economy.
Inflation
Inflation is an increase in prices generally. Money loses some of its value because its purchasing power falls. The main causes of inflation in any economy occurs when aggregate demand is growing faster than the aggregate supply. If aggregate demand increases rapidly in an economy, for example, due to a consumer spending boom, it may cause a demand –pull inflation if the aggregate supply of goods and services is unable to expand at the same rate. Inflation has a number of consequences:
- Borrowers gain- people and firms with high mortgages and other debt gain because inflation makes the debt smaller in real terms i.e. income and sales revenue increase in line with inflation, while debt repayments remain the same.
- Savers lose- money saved, in terms of inflation, loses some of its value. The same amount of money now buys fewer goods.
- Inflation increases uncertainty- in times of high inflation it is very difficult for individuals and firms to plan for the future.
Monetary policy will aim to reduce the growth in aggregate demand by raising interest rates. This will make borrowing money more expensive for consumers and firms. Conversely lower interest rates are used by Monetary Policy to boost aggregate demand as people have more money to spend on goods and services.
Graph to show Interest Rate Change and CPI Inflation (Consumer Price Index) Change in the United Kingdom
From the graph, interest rates began at 5.21% at the start of the ten year period and steadily increased to about 5.80% in the second quarter in 1995 and then reached its high in 1998 of 7.3%. But from about 1999 onwards interest rates decreased steadily until it reached the lowest point at 3.50% in 2003.
Inflation rates, over the same period, reached its peak of 7.7% in the 4th quarter of 1995 and steadily decreased until 2000 to about 1.4%. From then on inflation rate was stable.
The graph on the follow page shows that Monetary Policy has succeeded because over that time period it has been able to first lower inflation and then stabilize it at a low rate.
These two separate graphs show clearly how theses two variables of inflation and interest rates affect each other. They show an inverse relationship between the two. As interest rates fall, inflation increases and vice versa. For example, interest rates rose from 1996-1997 and inflation rates decreased sharply in the same time period. However, any changes in interest rates may take up to two years to filter around and the economy may not feel the true effects of it for some time.
Source= www.hm-treasury.gov.uk
These two graphs show that the main control of inflation is interest rates and that the monetary policy is essential to keeping the balance between aggregate supply and aggregate demand. If the aggregate demand gets too high then inflation is caused and interest rates are used to bring aggregate demand down and discourage spending and investment. The MPC’s target for the rate of inflation is currently 2.5% (plus or minus 1%) and from 1997 onwards the rate of inflation has been below that target. Therefore, I believe that Monetary Policy has been successful in controlling inflation.
Unemployment
It is important to keep unemployment levels as low as possible. High unemployment is expensive for the Government and there are several costs associated with any unemployed worker. First the unemployed person is entitled to state benefit, which is ultimately paid by the tax payers. Secondly, if a person isn’t working then they are not paying any tax so the Government doesn’t benefit. Also, there is the cost to the whole economy in terms of unused resources, which of course leads to a loss of potential output.
When interest rates are low it is cheaper to borrow, which leads to higher consumer expenditure and higher investment in machines and buildings by firms. The overall increased demand helps creates jobs and helps reduce unemployment. Conversely, higher interest rates have the opposite affect and lead to unemployment.
Graphs to show Base Rate and Unemployment Rate in the United Kingdom
From the graphs, you are able to see a direct relationship between the two variables. According to the theory, as interest rates increase then unemployment levels should increase and vice versa. The base rate line graph shows that there was a decrease in interest rates from 1997- 2003. On the pie chart there is evidence of this because from about 1997 onwards there is a slow but steady decrease in the amount of workers unemployed. Conversely, when interest rates were increased from 1996- 1997 the unemployment levels increased to 14% of the UK unemployed. But, as always, there is a lag in the data because it can take a couple of years for the interest rate change to affect the economy and unemployment levels. Also, there are other factors which may have caused the unemployment levels to decrease sometimes without being effected by interest rates (e.g. in 2000 the base rate increased but the unemployment levels continued to fall). The factors that could have affected unemployment might be the workers willingness to work regardless of a reduction or increase of pay and sometimes it depends on when the work is needed e.g. seasonal work
From this data, Monetary Policy has been quite successful in reducing unemployment throughout the given time period. Since 1995, unemployment has been reduced by 6%- 7%
This graph is a perfect example of what Monetary Policy sets out to achieve and what it has achieved. As you can see there is a link between GDP and Employment. As GDP increases so does employment. By reducing unemployment and increasing employment by lowering interest rates Monetary Policy is able to increase economic growth which is an important objective. So by reducing interest rates Monetary Policy is able to achieve some of its important objectives in the economy.
Balance of Payments
The balance of payments is a record of all transactions associated with imports and exports together with all international capital movements. The balance of payments has two accounts; the Current Account and the Capital and Financial Account. For our purposes the most important is the current account because it records how well the UK is doing in terms of its exports of goods and services, relative to its imports. It is a record of the visible and invisible exports and imports in Britain. If British companies import more products than they export then the current account is in deficit. In the same way if we buy more of our own goods than foreign imports we will have a surplus.
The capital account shows us the investment in and out of the country, It also shows us the speculation i.e. the overseas purchasing of £’s, stocks, shares etc. If we have more investment and speculation coming into the country then we will have a surplus. If we have less coming in to the country we have a deficit.
A rise in interest rates can attract investment from foreign investors who are seeking a better reward for their money. The increased demand for the pound appreciates the pound in relation with other currencies- the exchange rate appreciates. However, when the pound the pound becomes stronger in relation to other currencies it means that are exports become more expensive and therefore less desirable. Invariably, this will mean that there is a deficit in the current account.
If a developed country has a current account deficit, it can usually attract enough foreign investment on the Capital and Financial account to balance the books- it can finance the deficit.
Low interest rates will conversely lead to a lower exchange rate making our exports more desirable and our imports less desirable because of the increased cost. This will tend to a lead to a current account surplus.
Graphs to show the Base Rate and Balance of Payments Current Account in the UK
The UK Current Account has been in deficit over the last ten years. Nonetheless, this deficit is smaller than it was in 1990. From the two graphs you are able to see that there is a relationship between the two variables. As you increase the interest rate, you increase the deficit and as you decrease the interest rate you reduce the deficit.
Source= www.hm-treasury.gov.uk
For example, from 1997- 1999 interest rates decreased and so did the deficit as the line moved closer towards the 0 on the Current account balance graph. However, from 2000 onwards the theory almost doesn’t apply because interest rates decreased but the deficit increased. I am unable to apply the Monetary Policy theory to this set of data. In my opinion, it is because of external factors and variables which I am currently unable to analysis.
Summary and Conclusion
As a general sum up of all these effects, if you increase the interest rates, then you slow down the economy and if you decrease the interest rates you speed up the economy. This power can be use to control the effects of the boom bust cycle in both the economy and in separate industries, e.g. housing. It can also affect inflation and can be used to keep inflation in check. Changes in interest rates take time to affect the economy, as they change aggregate demand and eventually inflation over a period of time. So interest rates have to be changed with an eye to the future and the level of inflation in 18 months time
The interest rate transmission mechanism can affect everything as changes in production can in turn lead to changes in employment. This is because people demand less so we produce less and need fewer workers.
However, monetary policy, which uses changes in interest rates to control the level of aggregate demand cannot be used by itself to make a stable economy. It has to be used with other policies that help to complete the four macroeconomic objectives which are low inflation, high employment, steady economic growth and balance of payments equilibrium. From my investigation you can see that monetary policy can be used to affect all these things, however, together with, fiscal policy and supply side policy the economy can be kept stable.
There is a draw back with all the policies except the supply side policy, they all use aggregate demand to change their economic growth. This is because government spending and consumer expenditure are changed by fiscal policy and our imports and exports are changed by the exchange rate policy. All these things are in the aggregate demand formula.
If you use demand to control your economy you end up with a large problem and this problem is inflation. This can be seen on the aggregate demand diagram.
You can see that although you have a significant increase in the output you also have a large increase in inflation. Inflation is not very good for the economy and t will eventually undermine economic growth. One of the economic objectives is low inflation and another is steady economic growth. If you want economic growth as well as low inflation you cannot use the monetary policy or the fiscal and exchange rate policy. This is because they all rely on aggregate demand as to stimulate growth.
The one policy that you can use without increasing inflation to such an extent is the supply side policy that uses an increase in supply to increases aggregate demand.
From all of the information that I have gathered you can see that interest rates are used as an affective way to control the economy. This was proven in the graphs, as there was a definite correlation between the interest rate and the other variable in most cases. However the monetary policy alone would not be able to control the economy. This is because while solving one problem it may cause another problem like high inflation that needs to be solved using other policies and improving education and health and all the other variables that can affect our economy.
Monetary Policy needs to be used in conjunction with other economic policies in order to achieve the main economic objectives.
Bibliography
Books
- Longman study guides – economics.
- Complete A-Z economics handbook- by Nancy Wall
- Economics- A Complete Course- by Dan Moynihan and Brian Titley
Internet
www.hm-treasury.gov.uk