Interest Rates—Monetary Policy

Use of interest rates—monetary policy

Interest rates are the cost of borrowing money. If you were to borrow £1000 over 1 year, and the interest rate was 15%, then the total amount repaid would be £1150, £1000 plus £150 interest

There a many different interest rates charged in the UK. A mortgage may charge an interest rate of 6%, but spending on a store credit card is likely to have an interest rate of 25%!

The amount of interest charged depends on a number of factors. These include, the purpose of the loan, the security offered, the time span of the loan, the risk involved, and the current level of the Bank of England Base Rate.

The Bank of England Base Rate

The Base Rate is set by the Bank of England—it is a strong guide to other banks how much interest they should charge. If the Base Rate increases, then the amount charged by banks to their borrowers also increases. If the Base Rate goes down, then the interest rates charged by banks will also fall. So the Base Rate to a large degree determines the rate of interest charged by all lenders.

On coming to office in 1997 the Labour government gave control of interest rate policy to the Monetary Policy Committee of the Bank of England. The MPC is given an inflation target by the government (2%, plus or minus 1%), and by use of interest rates has the job of keeping inflation within the target band. Theuse of interest rates to control inflation and the level of economic activity is known as monetary policy.

Interest rates are an effective method of managing economic activity (the amount of demand in the economy) because they will directly affect the cost of borrowing money.

Effects of changes in interest rates

Increased interest rates

·people spend more on paying mortgages, so less money left over for spending

·people are less likely to borrow as the cost of loans has increased, so less spending

·firms borrow less for investment

Decreased interest rates

·people spend less on paying mortgages, so more money left over for spending

·people are more likely to borrow as the cost of loans has fallen, so there is more spending

·firms borrow more for investment

The MPC sets the Base Rate, which is an indicator to banks and other lenders of the interest rates they should charge. At the time of writing (March 2011) the base rate (set by the MPC of Bank of England) is just 0.5%. This rate is in reaction to the recession in the economy and the problems in the banking system (the credit crunch). This low rate is not at all typical, rates have for the last 10 years been between 3 and 6% and within the last 20 years the base rate has been as high as 15%.

If interest rates increase, the cost of borrowing increases, this will limit demand in the economy. If interest rates fall then the cost of borrowing falls, so demand will increase. Interest rates are then an effective tool for controlling demand in the economy, but there are problems.

Increases in interest rates push up the cost of existing borrowing for firms and make investment by businesses more expensive, so increasing costs to firms. These increasing costs can reduce profitability, so reducing tax revenues for the government and decreasing competitiveness of businesses, meaning lost orders and exports. Higher interest rates discourage investment by firms, as higher repayments on loans reduces the profits made on new investments, but investment is needed to make the economy grow.

From the individual’s point of view increased interest rates can have disastrous consequences. High interest rates in the late 80's and early 90's massively pushed up the cost of mortgages, meaning that many individuals who had been encouraged into the housing market by easy credit and booming house prices, lost their houses as they could no longer afford the repayments. The chancellor of the time justified this by saying 'if its not hurting, its not working'.

As most people have some sort of borrowing, whether it is a mortgage, car loan, credit or store cards, an increase in interest rates reduces the amount of money left over after the interest on the debt has been paid. So less spending on clothes, holidays and other luxuries.

On the other hand very low interest rates affect savers – the income they receive from their savings is reduced lowering spending power– and the standard of living of those who have saved for their retirement. This has been a real problem over the last few years, with interest paid by banks falling to 1 or 2%.