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In reality, the Bank of England's determination of the official interest rate is obviously a far more complex matter, taking into account many factors, such as house prices, consumer spending, exchange rates and most importantly inflation.
The Bank of England's ability to set interest rates is one of their most useful and effective tools in assisting them in maintaining economic stability. As inflation rates have a knock on effect on unemployment levels and general economic prosperity, the current economic situation of the UK is of key significance when determining changes in interest rates. For example, if it is believed that inflation is getting out of control, it may be the case that interest rates are raised in order to moderate demand and in-turn moderate inflation. This is the case as such changes affect the spending and savings decisions of millions of households and businesses throughout the economy.
In relation to this, the factors affecting changes in interest rates will be concerning either households or the corporate sector, both of which having significant influence. In relation the household, one of the most important factors is that of the house market and house prices, as any change in interest rates will affect mortgage rates and can have severe effects on the economy in general. If interest rates are raised, the cost of mortgages will increase and thus the demand for most types of houses will fall. Alternatively, a cut in interest rates should stimulate higher market demand and lead to an increase in house prices. If the Bank of England see the UK housing market as being too weak or too strong they can take the necessary action to create stability. For example;
The cut in interest rates from 7.5% in Oct 1998 to 5% in June 1999
was said to be a major factor in the acceleration in housing market
activity during the summer of 1999. Equally, the series of increases
from 5% in June 1999 to 6% by Feb 2000 helped take some of the
extra demand for housing out of the market and contributed to a slow-
down in the rate of house price inflation during summer 2000.
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As well as effecting house prices and the demand for house buying, changes in interest rates, and the related changes in mortgage rates also has the effect of changing the effective disposal income of mortgage payers. For example, if interest rates fall, the disposable income of home owners who have variable mortgages will increase, and they will therefore have more money to spend. This can be shown in the following diagram, were high interest rates are accompanied by low consumer spending and vice-versa;
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Here, we can see a distinct relationship between mortgage interest rates and consumption, and can therefore understand one way in which the Bank of England can gain the required rate of inflation by adjusting such rates. It must also be noted that although those homeowners with fixed rate mortgages will not be effected to the same extent, the effect that interest rate changes can have upon those with variable rate mortgages is a phenomenon particular to the UK economy as in the majority of European nations a far smaller percentage of the population rely on such mortgages.
Another way in which inflation can be directly affected by interest rates is that lower interest rates tend to promote higher spending as people are more inclined to buy on credit or to take out loans and less inclined to save. Therefore, when interest rates fall there is a redistribution of funds away from lenders and towards the consumer, and this is therefore another way in which interest rate changes can be used by the Bank of England to keep inflation rates under control.
In relation to the corporate sector, it is generally seen that a fall in interest rates will help increase business confidence and make such businesses more inclined to take out loans to invest in corporate development and expansion plans. Therefore, when deciding on interest rates the Bank of England must also take into account how successful and profitable UK industries are and whether or not they need to be stimulated by raising the level of planned fixed investment.
Finally, another factor of crucial importance when determining interest rates is the current strength of the British pound. An increase in interest rates relative to those in other countries will tend to result in an increase of funds flowing into UK, as investors are attracted to the higher rates of return they will receive on their investments. Such changes in interest rates could therefore have the effect of increasing the value of the pound which will reduce the price of imports and may therefore, once again, have a direct effect on inflation.
In conclusion, it must therefore be said that there are many factors that effect interest rate developments within the UK, but most tend to concern themselves with the Bank of England and Governments attempt to achieve the desired rate of inflation and therefore maintain a stable economic environment. When deciding on interest rate increases or decreases the Bank of England need to first of all establish whether inflation is getting out of control and whether there is cause to alter interest rates in response. Within this analysis, they will need to decide whether they are happy with elements such as the strength of the housing market, the level of consumer spending, the level of debt and/or savings, the level of corporate growth and also the strength of the British pound. It must however be remembered that although it is the stability of the UK economy that most directly effects interest rate developments, there are inevitable time lags involved and it is the general assumption that it takes approximately a year for interest rate changes to feed through to the economy and a further year for their impact to become relevant in price levels. Because of this, the Bank of England needs to base their decisions partly on their estimations of the state of the UK economy at a certain point in the future and not necessarily now.
WORD COUNT:1310
BIBLIOGRAPHY:
BOOKS:
Sloman J & Sutcliffe M Economics For Business - Second Edition FT Prentice Hall 2001
WEB SITES:
http://bss.sfsu.edu Market For Loanable Funds Graph
www.bankofengland.co.uk/mpc/ Monetary Policy Committee 2004
www.bankofengland.co.uk/targettwopointzero/inflation How Do Interest Rates Affect Inflation? 2004
www.bbc.co.uk/1/hi/business/1749761.stm Which Way for UK Interest Rates? (article) 2002
www.homepages.uel.ac.uk/K.Bain/interest.html The Determination of Interest Rates 2004
www.iea.org.uk Shadow MPC Votes to Raise Interest Rates (article) 2004
www.tutor2u.net/economics/content/topics/consumption/mortgage_rates.htm Mortgage Interest Rates and Consumer Demand 2004
www.tutor2u.net/economics/content /topics/monetarypolicy/effects_of_changes.htm Interest Rates and Economic Activity 2004
