The bank is a supplier of money, and they are able to offer loans with funds that they have and offer an interest rate on this, affecting the amount people plan to hold using that bank. The interest rate that banks charge is determined by how much the Central Bank charges those for their deposits, and then the banks set the rate higher than this. The rate the Central Bank charge is called the repo-rate. If the repo-rate was increased, commercial banks would have to increase there rate; an increased interest rate would decrease the quantity of money demanded and vice versa. This is because people would benefit from earning a higher interest on the moneys that they hold rather than having to pay a higher price for borrowing i.e. the opportunity cost rises. As illustrated by Fig 1, the ‘demand for Money’ curve slopes downwards:
Fig 1: Demand for Money:
An increased interest rate would influence banks to lend more money as they would have more deposits to supply and would want to reserve less as they would benefit from charging at a higher interest rate. So, the opportunity cost for the banks is the reserves they have. There would be more supply because economic activity would have dropped since individuals would not want to be spending and investing as much since it is costing them more for the money they are borrowing. This is shown in Fig 2 where the ‘Supply of Money’ curve slopes upwards:
Fig 2: Supply of Money:
The interest rate will be set at equilibrium in the money market, where the money being supplied equals money being demanded. By combining the supply and demand for money curves we can find the interest rate. The interest rate adjusts so that it influences how much money is actually being demanded according to the supply, so it is used to manage economic behaviour. The equilibrium is shown in Fig 3, where the two curves meet making the interest rate 5%. If the interest rate was above the equilibrium point, there would be a surplus of money so the interest rate would decrease to encourage people to spend more as they would be holding more than they want. If the interest rate was below equilibrium, the interest rate would then increase as the shortage of money would direct people into holding more money. Therefore, what determines the interest rate and causes it to change is when the demand for money begins to fluctuate – when demand drops, interest rates drop and vice versa.
Fig 3: Money Market Equilibrium:
The Central Bank uses interest rates as a tool by setting the rate to achieve there objectives, the most important being lowering inflation and maintaining price stability. This affects economic growth as maintaining a low inflation aids good economic development and price stability helps maintain a steadier demand for money (thus influences interest rates).
Economic growth is the expansion of the economies production possibilities, which can be measured in GDP (gross domestic products) to show the value of total production in each country (Parkin et al, 2005). An increase in GDP is a sign that the economy is in growth and the higher the GDP, the better the standard of living there is in the country. This is because there is more consumption possibilities that allows more healthcare availability, a cleaner environment and generally society would be operating more efficiently. Two explanations of economic growth are either there are more goods and services being made available to the economy or, people are able to pay higher prices for the goods and services.
There a strong link between economic growth and interest rates. If interest rates are low then the opportunity cost has reduced. Investments made by businesses would be increasing and borrowing of funds by people would be increasing to allow them to do more things. More investments being made would be for business development within the economy; boosting small and large businesses and earning them higher profits. Subsequently, if businesses make investments and consequently more jobs are created, unemployment reduces and more people are making an income. If more people are receiving wages, there would be more expenditure spreading more wealth in the country.
It is not only beneficial for businesses and people in the country, but for the Government. There would be less Government expenditure on things like unemployment benefits, and they would be collecting more taxes to then put into use for the country. All in all, a lower more reasonable interest rate affects economic growth advantageously.
However, by having more capital, more would be spent with the employment of resources – importantly the use of non-renewable resources which will be depleted. This is not the only negative effect of economic growth; inflation is also another major disadvantage. According to the monetary transmission mechanism, there would be changes in inflation in the process; if there is economic growth as a result of people paying higher prices for goods and services, prices could carry on rising. Individuals would have to spend more and the value of their money will reduce and force them to save on a low interest. So, purchasing power and market value would reduce and the economic growth would not sustain since making investments would be much riskier.
The solution would then be to increase interest rates accordingly to effect the growth in economy. Because the problem is that individuals and businesses are spending at a faster rate than what the economy is growing at, increasing interest rates discourage expenditure as they would have less disposable income as loan/mortgage etc repayments have increased. Saving would earn them more so it would be more desirable. For example, if the commercial bank Abbey National rose there interest charge on mortgages from 4.24% (which it currently is set to) to 5.24%, this would be too much of a dramatic increase. In the economy, taking a monetarist view of employment operating at full capacity as long as monetary policy is not erratic (Parkin et al, 2005), the economy would not be efficient with this dramatic change.
As discussed, interest rates set by the Central Bank are a major influence on spending behaviour by individuals and businesses. This in turn influences price levels set and GDP, and GDP measures economic growth. As the supply of money and the demand for money influences the interest rate, economic growth is affected when the interest rate is forced to move by the demand for money. Also shown, is that interest rates affect the economy hugely, because they affect the amount people can invest/spend into the economy and how much Government can spend to better the economy as well.
Bibliography
Books
Parkin, M; M. Powell & K. Matthews (2005) Economics 6th Edition (Addison-Wesley)
Web sites
www.bized.ac.uk
www.bloomberg.com/markets/rates/uk.html
