Revision on Interest Rates
When revising monetary policy for AS and A2 level here are some of the key concepts and issues
to be aware of. As you work through this revision note – tick in the table when you are confident
that you understand each point!
•
The main aim of monetary policy is to help keep macroeconomic stability in the economy
and also to maintain the value of money – i.e. achieve price stability
•
There is no unique rate of interest in any economy – indeed there are thousands!
•
Policy rates
o
These are the official short term interest rates set by central banks such as the
US Federal Reserve and the Bank of England.
o
A change in the UK base rate means that the Monetary Policy Committee wants to
move interest rates in a different direction
ƒ
Lower rates – a relaxation of monetary policy / policy stimulus
ƒ
Higher rates – a tightening of monetary policy / policy squeeze
o
There is no automatic link between a change in policy rates and interest rates on
savings, credit cards, bank overdrafts and mortgages
o
But – generally speaking – interest rates do tend to move in the same direction
because the Bank of England has the power to intervene in financial markets if it
needs to
o
However – as we have seen during the current credit crunch, a gap can emerge
between the policy rate and (for example) the inter-bank lending rate (known as
LIBOR) (as of Apr 2nd – LIBOR is 6% and the base rate is 5.25%)
o
Another example has occurred in 2008 – base rates have been falling but
mortgage interest rates have been rising
Other interest rates that you need to be aware of
Rates on ‘unsecured credit’ such as
Bank loans
Overdrafts
Credit cards
Mortgage interest rates
Fixed rates
Variable rates
Tracker rates
Bond yields
Interest rate on different types of government debt
Ten year bonds
Twenty year bonds
Real interest rates
Interest rate adjusted for inflation
= Money interest rate – rate of inflation
Savings interest rates
Current accounts
Deposit accounts
How do interest rates affect the economy?
For AS level you need to understand how a change in interest rates affects variables such as
aggregate demand / output / the output gap and demand-pull and cost-push inflationary
pressures.
This bit of analysis is called the transmission mechanism of monetary policy
One way of showing this is to use a flow diagram – see below
Market Rates
Domestic
Demand (C+I+G_
Asset Prices
Total Demand
(AD)
Domestic
Inflationary
Pressure
Net External
Demand (X_M)
Official Base
Rate
INFLATION
Expectations /
Confidence
Exchange Rate
Import Prices
A change in interest rates needs to affect other market interest rates to have an effect. If this
happens then interest rates will have an impact on
1. Consumer behaviour
a. Consumer confidence
b. The marginal propensity to save
c. The demand for loans
d. Monthly mortgage interest payments
e. House prices – which then affects mortgage equity withdrawal
2. Business behaviour
a. Business confidence
b. Expected growth of sales / consumer demand
c. Cost of loans
d. Possible impact on planned capital investment
e. Expected growth of exports (if there is a change in the exchange rate)
Exchange rate: One point often ignored by AS students is the effect that a change in interest
rates can have on the exchange rate. Make sure that you are aware of this and can build it into
your analysis.
The conventional view is that higher interest rates might lead to an appreciation of the exchange
rate because of an inflow of hot-money. If the exchange rate appreciates, this will reduce the
price of imported goods and services (helping to reduce cost-push inflation) and also make
exports more expensive overseas (a possible fall in AD / fall in injection of demand)
A2 revision on monetary policy
For A2 level, a more sophisticated understanding of monetary policy is required – here are some
ten important pointers of the issues you need to have covered in your revision for Unit 6.
1. Factors that the Monetary Policy Committee take account of when setting interest rates
a. Forward-looking nature of monetary policy (i.e. being pro-active)
b. Demand and supply side factors
c. The concept of the neutral rate of interest
2. Roles played by inflation targets + how monetary policy can maintain economic stability
a. Why have inflation targets?
b. Does the UK have the wrong inflation target?
3. Interactions between monetary and fiscal policy
a. E.g. the “crowding out” hypothesis
b. Deeper understanding of determinants of the exchange rate under fixed and
floating rate systems
4. Evaluation of the effects of monetary policy on an economy
a. Uncertain and variable time lags between rate changes and macroeconomic impact
b. Understanding that what often matters is a change in the real interest rate
c. Asymmetric effects of a rate change – an interest rate change does not have a
uniform effect on the economy
i. Variations in the interest elasticity of demand (e.g. consumer durables v
basic foods v demand for new housing)
ii. Impact on the traded goods sector through the exchange rate
iii. Impact on the regional economy (some regions are more exposed to the
exchange rate than others)
iv. Differential impact between savers and borrowers
v. “One size fits all” monetary policy – does not apply to the UK let alone the
members of a currency union!
5. Understanding that monetary policy works mainly through aggregate demand – in the long
run, monetary policy should be neutral in terms of LRAS – but is that the case?
6. When does monetary policy become ineffective?
a. Awareness and understanding of the meaning of a credit crunch
b. Awareness and understanding of the possibility of the liquidity trap
7. Evaluate the performance of the Bank of England since it became independent
8. How monetary policy can influence expectations of businesses and consumers
a. Link to the expectations-augmented Phillips Curve and the NAIRU
b. Changes in expectations affect most of the components of aggregate demand
9. Understanding of the external shocks that can affect an economy and how monetary
policy can be used to help stabilise the economy and absorb some of these shocks
10. Awareness of the arguments for and against countries entering into a currency union
Who gains and who loses from lower interest rates?
A homeowner with a variable rate mortgage of £280,000
A pensioner couple who have paid off their mortgage and have some savings in a
building society account
A young married couple with few savings who find that they cannot afford to buy
their first property
A travel agent, 70 per cent of the holidays they sell are to British consumers to
overseas destinations
A manufacturer of kitchen units in the West Midland with a high level of bank loans
Workers in a UK factory that makes and exports sports clothing to the United States
Recent trends in interest rates
Your revision note
Trying to Stem the Credit Crunch
Percentage, since May 1997 base rates have been set by the Bank of England
7.0
7.0
Percent
6.5
6.5
London Interbank 3-Month Interest Rate
6.0
6.0
5.5
5.5
5.0
5.0
4.5
4.5
4.0
4.0
Bank of England Base Rate
3.5
3.5
3.0
3.0
00
01
02
03
04
05
06
07
08
Source: Reuters EcoWin
Your revision note
The Price of Unsecured Credit
Per cent, source: Bank of England
18.0
18.0
17.5
17.5
17.0
17.0
Credit cards
16.5
16.5
Percent
16.0
16.0
15.5
15.5
Overdrafts
15.0
15.0
14.5
14.5
14.0
14.0
Personal loans
13.5
13.5
13.0
13.0
Jan
Mar May
Jul
05
Sep
Nov
Jan
Mar May
Jul
06
Sep
Nov
Jan
Mar May
Jul Sep Nov
07
08
Source: Reuters EcoWin
Check your understanding with these multiple choice tests:
AS Economics: http://vle.tutor2u.net/mod/quiz/view.php?id=1478
A2 Economics http://vle.tutor2u.net/mod/quiz/view.php?id=1510