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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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Introduction

What effects have interest rates had on economic indicators like GDP, Inflation ,Unemployment and Balance of Payments in the last ten years? Title of Page Page Number Introduction 3 Background Knowledge 4 Transmission Mechanism 5 The Economics of Interests Rates 6- 7 How Interest Rates affect Economic Indicators 8- 15 Summary and conclusion 16- 17 Bibliography 18 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. ...read more.

Middle

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. ...read more.

Conclusion

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. ...read more.

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