Discuss the extent to which a reduction in the rate of interest can be effective in increasing consumer expenditure and investment.

Discuss the extent to which a reduction in the rate of interest can

be effective in increasing consumer expenditure and investment.

Interest rates are rates charged by the banks and financial institutions on borrowers and savers and depend hugely on the base rate set by the central bank. A cut in interest rates is mainly used in monetarist policies, and in this case a cut in interest rates will belong in a loose monetary policy. Interest rates are normally used to influence levels of aggregate demand.

Lower interest rates would mean that saving becomes unattractive as the rate of return on savings is much less, it would mean that mortgage payments will also be lower as it is based on interest rates and also credit is easier to obtain. Consumers will therefore increase their spending on goods and services within the economy as their discretionary income would have increased dramatically. Increases in consumer expenditure will most likely increase aggregate demand as consumer expenditure is a component of aggregate demand. Increases in aggregate demand will promote further rounds of spending in the future as unemployment levels will be lower and economic growth will be higher hence giving consumers more confidence to spend more, therefore interest rates are effective in increasing consumer expenditure.

Lower interest rates will also increase investment levels within the economy due to the same reasons mentioned above that will increase consumer expenditure. Lower interest rates would mean to businesses that rate of return from banks or financial institutions will be much lower than the return from investment projects. Increases in aggregate demand, shown below, will be a catalyst for further rounds of investments as due to the accelerator model, firms will have to expand output to meet increases in demand from the economy hence will need to invest more.

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However the reduction of interest rates may not after all affect levels of consumer expenditure and investment. The reasons for increases of consumer expenditure and investment levels as mentioned above are all valid if ceteris paribus is assumed. However in reality both factors of aggregate demand can be affected by many other external factors.

Consumer expenditure can be affected by the marginal propensity to consume; therefore if a country has a low level of marginal propensity to consume then a reduction in interest rates actually makes very a tiny difference to consumption levels. Consumer expenditure can also be affected by income elasticity of demand; both reasons can reduce the effectiveness of a reduction of interest rates on consumer expenditure.

A cut in interest rates as shown on the diagram will increase aggregate demand; however increases in aggregate demand will have tradeoffs, although it causes an increase in employment and economic growth, it does lead to higher rates of inflation and deterioration of balance of payments. Rises in inflation will have negative aspects on both levels of consumer expenditure and investments levels.

Increases in inflation levels will reduce investment as business confidence will be also lowered. Higher inflation rates reduce consumer expenditure as a rise in inflation will mean that pensioners will lose out as their savings will be worth much less than before hence can spend as much; savers will also be hit hard as the effects that will affect pensioners. The combination of these effects will actually reduce consumer expenditure. However savers and pensioners only make up a small percentage of the overall spending by the general population hence an increase in spending by middle aged to around eighteen would actually compensate easily for the decrease in spending from pensioners and savers.

In conclusion, a cut in interest rates is a very simple solution to increase consumer expenditure and investment levels in the short term. However there are factors that reduce the effectiveness of a reduction of interest rates such as the fact that interest rates will lead to increasing inflation and the effects is not sustainable as once the economy is at full capacity then no further expenditure and investment levels in the future can be achieved. There are also other alternatives to increases consumer expenditure and investment levels such as the introduction of supply side policies, for example increases in provision of education.

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Peer Reviews

Here's what a star student thought of this essay

groat

12th of Mar 2012

Quality of writing

The essay has a strong structure, with a clear introduction and conclusion. The introduction defines the key terms, and summarises the points of the essay. I liked the progression throughout the essay. It begins with knowledge, then explains how interest rates affect consumption and investment through analysis. Then there is a perceptive debate about the effectiveness. Being able to show this progression will make it easy for examiners to allocate marks, and it shows a strong and convincing writing style. Technical terms are used fluently. It just needed to address the "extent"!

Level of analysis

The analysis is strong here, as mechanisms are well explained. For example, the first paragraph explores each step from the interest rate decreasing to the final increase in aggregate demand. Being able to explain how each step follows from the last is a good skill, and this essay does it fluently. I particularly liked the discussion of the accelerator model, and the diagrammatical analysis as this shows a strong understanding of what interest rates contribute to. There is a limitation in the diagram, though, and I would always advise using a Keynesian long run aggregate supply (LRAS) curve. I say this as it allows evaluation of the effectiveness depending upon what the previous macroeconomic equilibrium was, and where this was on the curve. It was nice to see an awareness of the ceteris paribus argument, as consumption and investment are heavily influenced by external factors. It would've been good if this argument was elaborated upon by saying that the Monetary Policy Committee therefore have to make a difficult value judgement of how much to reduce interest rates by. To address the question of "to what extent" the essay needed to discuss the size of the decrease in interest rate, following onto a discussion of what happens if the interest rates are already low (and therefore ineffective).

Response to question

This essay engages well with the task, looking at how interest rates increase consumption and investment, and then looking at factors which limit the effectiveness of this policy. If this essay wanted to get the top marks, it needed to be explicit when discussing "the extent to which it is effective". In my opinion, the foundations for this are already there in the conclusion, it just needs a few sentences such as "The effectiveness depends upon the marginal propensity to consume" etc.

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