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Impact of Low-Interest rates on British economy

Describe about a Case Study Of British Economy for Effects Of Lower Interest Rate.

From the past few years, the UK economy is facing a very low-interest rate as calculated by World Bank. During the time with low-interest rate, the spending of the people of UK has increased and investors find it attracting to invest more. As spending level started rising, the aggregate demand of British people except the retired persons has also increased. Therefore, UK economy can achieve an increasing trend of growth. However, with higher aggregate demand, demand pull inflation has arisen in the British economy. The sustainable economic expansion can be damaged (Kirby, 2013). The Central Bank of England should take major actions to control this worse scenario by altering the monetary policy.

In this report, impacts of low-interest rates have been shown by taking the help of approaches of microeconomics and macroeconomics. This report will also show the policies taken by Central Bank of England which can alter this worse situation of UK.

When there is low-interest rate prevailing in UK economy, there are certain effects which can be discussed briefly. The lower interest rate has enhanced the spending of the individuals and savings became lower. It has decreased the currency value (Sensoy and Sobaci, 2014). The exchange rate downturn leads to more export and country can face capital outflows. As imports became costlier, (X-M) is negative. The lower rate of interest has made the costs of borrowings very low and hence, it is attracted for the citizens to take loans for rising spending. The firms are also taking loans to finance the ventures. People have found it foolish to save the money as they would get lesser yields because of lower interest rates. Rationally, it can be said that the citizens would spend money in purchasing goods and services rather than save it. The British people have attracted to purchase houses and other assets (Berdin and GrÃndl, 2015). Then house prices would rise and hence the wealth. There are lower mortgage costs can be seen in the case of lower interest rate.  Thus, the disposable income would rise.

Now, the macroeconomic theories can be applied to show the impacts. Rationally, the model of aggregate demand can be used to depict the impacts of lower interest rate. The equation of AD can be written as:

AD = C+I+G+ (X-M),

Where, C = consumption, I = Investment, G = Government expenditure, (X – M) = Net export. When there are low-interest rates prevailing in UK economy, the elements of AD such as (X-M), C, I have increased. With the increase of aggregate demand, the economic growth of UK will be higher. Figure 1 will help to see the relationship between AD and interest rate (Colander, 2013).

British economy and lower interest rates

Shifts in AD with Lower interest rate

Figure 1: Shifts in AD with Lower interest rate

Source: (Beveridge, 2013).

AD curve to the right (AD1) as spending has raised due to a lower rate of interests. AS curve remains the same. From the figure 1, it can be said that National Income has been stimulated from Y to Y1 as AD has increased for a lower rate of interests. Therefore, by taking help of the macroeconomic model, it can be said that although demand-pull inflation has arisen, but with the higher level of AD, the country has attained a higher level of growth.

The below table contains the data of past seven years’ interest rates which were very low.

Table 1: Interest rate data of past 7 years (%) (Data.worldbank, 2016)

Interest rate data of past 7 years

On the basis of table 1, the line graph can be made by excel to do the trend analysis.

Fluctuations in Interest rate

Figure 2: Fluctuations in Interest rate

Source: (Author)

It can be seen that after 2008, the rate of interest decline sharply to 0.6% and has stuck at 0.5% from 2010 to 2014. In the UK, people belonging from different groups can have different effects on this lower rate of interest. The mortgage holders along with the borrowers and also the homeowners have enjoyed benefits due to the lower rate of interest in the British economy. This person has spent more of the money to get maximum benefits. On the other hand, when the interest rate was lower, the UK citizens who had saved their maximum parts of income, had faced the worst effects. Mainly, the retired persons are belonging from this group. In this scenario, they had got low amounts from their savings and hence the disposable income became very low. This groups of people did not spend much money. A contradictory situation has arisen. In general, the British economy is referred to as the region of borrowers. Thus, debt mortgage became higher in this period of time. With lower interest rate, UK economy has faced noticeable impacts which have a serious need to manage. In this situation, the higher tendency of taking rented houses can be seen among European Union nations rather than buying a new home. When interest rate has gone down, exports became simulated and imports were costlier and thus (X – M) became negative. Current account thus affected adversely. However, on the other hand, people has spent more on goods and services during this period. The citizens of this economy have faced elastic demand. Thus, the researcher has may face dilemmas while describing this effect.

Expectations from Central Bank of England

The service sectors of UK have faced some adverse effects. Financial sectors of Britain have faced some turmoil for which the growth rate becomes negatively affected from the last 7 years.

Inflation rate in the UK

Figure 3: Inflation rate in the UK

Source: (Data.worldbank. 2016).

In Figure 3, the inflation rate fluctuation is shown. The inflation rate has decreased to 2.2% from 3.6% due to the debt crisis. Thus, the interest rate has decreased too in this period of time. In this period of time, the British economy became fragile and a recessive scenario has arisen.

To bring the UK economy back to its position, the citizens of UK has some expectation from the Central Bank of England. The Central Bank of England should do some improvisations in its monetary policy to bring the monetary stability as well as to manage the inflationary pressures in this scenario. It should try to control the social consequences along with the economic dilemmas (Hoffmann, 2014). The Central bank should remember some factors while trying to control the interest rate slowdown. While trying to manage the low rate of interest by doing modifications in the policies, the members of the authority must have the perfect information about the British economy, otherwise, “information failure” will arise (Pindyck, 2012).

The policymaker should consider the output gaps along with growth rate of GDP. Without having this information, it will be impossible for Central bank to manage the aggregate demand level in UK economy. Otherwise, information asymmetry can arise. In this case, the lending of banks along with the customer credit must be considered by the authority. The data of withdrawal of equity from the markets of housing, data on lending via credit cards should be collected because those data will help to analyze the customer spending (Sirichand and Hall, 2015). After collecting all data, it can be said that CBE will take an active role to control the downfall of interest rate. The CBE can perceive the monetary policy which is contractionary in nature. The contractionary policy will surely lower the spending of citizens which will shift the AD curve in a leftward direction. By doing this, the higher level of interest rate can be attained. The contractionary monetary policy will help to reduce the supply of money. It also lowers the customer's spending level. After reaching the higher level, it will raise the reserve requirements due to the reduction in money supply. When the higher interest rate is assigned by the authority, higher rate of borrowing by the banks and the government can be seen. The cost of lending will be higher. As other commercial banks will assign a higher rate of interest, it will lower the customer borrowing. Hence, the inflationary pressure can be managed. Apart from this situation, the higher rate of interest will make the savers satisfied. When saving rate will be increased, the group of retired people can slightly enhance their spending. The Central Bank of England can raise the requirements of reserves over other banks of Britain to regularly follow the withdrawals. As the reserve requirement is high, the commercial banks will not borrow from the people of Britain. Hence, automatically the spending of the British people will go down. In this way, the Central bank can manage the interest rates and the demand-pull inflation (Field, 2014). To reduce the supply of money, the CBE can follow the direct way or indirect way. When the greater demand has arisen, the contractionary monetary policy will enhance the exchange rate value (Olugbode et.al., 2013). It can raise the level of imports and also it will reduce the level of export in the same way. Thus, the velocity of money can be controlled fully by the CBE.

Conclusion

It can be concluded that the UK economy has faced a lower level of interest rates from few years. Various impacts of low-interest rate are discussed in the previous sections by taking the assistance of AD-AS model (Macroeconomics) and different concepts of microeconomics (Information failure, information asymmetry etc.). The citizens of UK economy have raised the spending in this situation which has led to higher growth level. However, demand pulls inflation has arisen. Thus, the CBE should perceive contractionary monetary policies which will raise the interest rate and control the inflationary pressures.

References

Berdin, E., and GrÃndl, H. (2015). The Effects of a Low-Interest Rate Environment on Life Insurers. The Geneva Papers on Risk and Insurance Issues and Practice, 40(3), pp.385-415.

Beveridge, T. (2013). A primer on macroeconomics. [New York, N.Y.] (222 East 46th Street, New York, NY 10017): Business Expert Press.

Colander, D. (2013). Macroeconomics. New York, NY: McGraw-Hill/Irwin.

Data.worldbank. (2016). Lending interest rate (%) | Data | Table. [online] Available at: https://data.worldbank.org/indicator/FR.INR.LEND

Data.worldbank. (2016). Inflation, consumer prices (annual %) | Data | Table. [online] Available at: https://data.worldbank.org/indicator/FP.CPI.TOTL.ZG/countries/1W?display=default

Field, M. (2014). Reappraising the place for private rental housing in the UK market: Why an unbalanced economy is at risk of becoming even worse... Local Economy, 29(4-5), pp.354-362.

Hoffmann, A. (2014). Zero-interest Rate Policy and Unintended Consequences in Emerging Markets. The World Economy, 37(10), pp.1367-1387.

Kirby, S. (2013). Prospects for the UK Economy. National Institute Economic Review, 226(1), pp.F46-F64.

Olugbode, M., El-Masry, A. and Pointon, J. (2013). Exchange Rate and Interest Rate Exposure of UK Industries Using First-order Autoregressive Exponential GARCH-in-mean (EGARCH-M) Approach. The Manchester School, 82(4), pp.409-464.

Pindyck, R. (2012). Microeconomics with MyEconLab Student Access Card. Harlow: Pearson/Education.

Sensoy, A. and Sobaci, C. (2014). Effects of volatility shocks on the dynamic linkages between exchange rate, interest rate, and the stock market: The case of Turkey. Economic Modelling, 43, pp.448-457.

Sirichand, K. and Hall, S. (2015). Decision-Based Forecast Evaluation of UK Interest Rate Predictability. Journal of Forecasting, 35(2), pp.93-112.

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