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Impact of Interest Rate on British Economy

Discuss about The Economics of Commercial Property Markets?

The interest rate is one of the major monetary policy aspects, which have a significant influence on the money supply in the economy and consequently the economic activities.  A high-interest rate affects the easy availability of the capital in the economy negatively, while lower interest rate increase the money supply and make the obtaining of capital sources easy for the individuals and the firms both (Houben, 2012).  This report analyses the impact of lower interest rate on the British Economy over the last 7 years with the use of microeconomic and macroeconomic theories. Along with this, it also includes the expectations from the Central Bank of England to mitigate these issues.

The UK interest rate is quite low from last several years. In the year 2009, it was dropped to 0.50%, which is still at the same level as below:

UK Interest Rate (Trading Economies, 2016)

UK Interest Rate (Trading Economies, 2016)

From the economic perspective, the lower interest rate has a significant influence on the economic growth due to the availability of capital and required funds to the investors and businesses in easy terms (Sloman and Jones, 2014). The low-interest rates in the last 7 years caused a decline in the cost of capital for the businesses and the individuals and contributed to increasing their income level. An increase in the income level also caused an increase in spending and consequently the demand and the production activities in the economy (Novales, et al, 2014). It is because lower interest rates made the borrowings cheaper and it caused an increase in spending and investment. From the theory of the economic growth of macroeconomics, it can be analysed that the lower interest rates were related to the economic growth objective of the economy, which dealt with the long-run growth of the income and consequently the output and employment (Lewis, 2013).

It is because lower interest rate led the higher aggregate demand and consequently the production activities and the requirements for the more people to fulfil the production activities. From the theory of economic growth, it can also be explained that this lower interest rate increased the economic growth of the country by increasing the employment and production activities. It is because the lower interest rate reduced the cost of borrowings and the also encouraged the customers and firms to take a loan for their investments and the financial spending (Novales, et al, 2014). On the basis of the theory of income of macroeconomics, the lower interest rates were effective to decline in the mortgage interest payment and consequently increased the disposable income and the consumer spending for improving their living standards (Means, et al, 2015). It is because this theory depicts that there is a relationship between the income, output and expenditure as an increase in income level causes an increase in output and the expenditures from the firms and individuals (Sloman and Jones, 2014).

Recommendations for Central Bank of England

But at the same time, according to the theory of prices, the lower interest rates also contributed to increasing the inflation level in the economy. It is because the theory of price exhibits that an increase in the quantity of money increases the price level in the economy at inflationary level. It is because the lower interest rate increases the income level of the people and consequently the demand for them that causes an increase in the demand from the level of supply and it creates the inflationary situation (Brigo and Mercurio, 2013). The below graph shows an initial increase in the inflation rate due to lower interest rates, but soon the government has taken various inflation control measures that caused a decline in the inflation rate, but in 2016, it rose slightly (Treanor, 2016):

UK Inflation rate (Trading Economies1, 2016)

UK Inflation rate (Trading Economies1, 2016)

This inflationary impact can be seen from the rise in the asset prices in the UK as on average there was 23% increase in housing prices during 2005-2015 in England while 19% rise in the housing prices of London (Croucher, 2016). Overall, in 2013, the housing price rise was 6.23%, while in 2014; it was 6.66% after inflation adjustment (Global Price Guide, 2015). Similarly, on the basis of the microeconomic theory of consumer behaviour, it can be determined that the lower interest rate affected the behaviour of the customers towards the saving due to decline in the overall return on their savings in the banks. In the last seven years, the household saving rates have increased to a significant level, but they are showing a downward trend now due to lower return to the people on their savings that have a significant influence on their income level (Barghini and Pasquali, 2015). The below graph shows the UK household saving rates over the last 10 years:

UK Household Saving Rates (Trading Economies2, 2016)

UK Household Saving Rates (Trading Economies2, 2016)

A decline in the return is the indicator of a decline in the economic welfare as it reduced the interest of the investors. Along with this, it is also affecting the level of saving from the foreign countries as the investors are finding the other countries attractive to save their money and it is causing a decline in the demand for UK currency and consequently, it depreciated the exchange rate. It also affected the import and exports of the firm as exports become more competitive while imports became more expensive (Peng, 2015). The below chart shows a decline in the trade of balance because of decline in the demand for UK currency and consequently a decline in the revenue from exports:  

UK Balance of Trade (Trading Economies3, 2016)

UK Balance of Trade (Trading Economies3, 2016)

From this, it can be determined that a lower interest rate in the UK has a significant influence on the import and export activities and it is causing a decline in the revenue from exports and consequently a deficit balance of payment. But at the same time, the low rates have a positive impact on the economy of Britain as it enabled the Federal Reserve to reduce the cost of mortgage-backed bonds along with reducing the cost of home ownership in the economy. The general investment model also depicts an inverse relationship between the interest rate and the investment in the new properties in an economy (Ball, et al, 2012). The increasing investment in the housing properties in the UK in the last 7 years can be determined by an impact of the lower interest rates as the investment model depicts an increase in the expectations of the people for higher outputs in the future time period and consequently increases the aggregate demand (Powell and Powell, 2015).

Overall, it can be determined that the lower interest rates in the UK increased the business investment, housing investments and a decline in the housing cost, but at the same time, it slightly increased the inflation rate, deficit balance of payment, decline in saving rates of households etc that are having a negative impact on the economic growth objectives of the British economy (Canocchi, 2016). Due to this, there is a need for the Central Bank of England to take some appropriate actions and steps to reduce its negative impact and to ensure economic growth.

From the Central Bank of England, it can be expected from the current conditions that the bank should make some slight changes in its monetary policy as per the change in the economic situation. In the current, the slight rise in the inflation rate may become worse in the future time period and for this, the Central Bank is required to consider a hike in the interest rate, so that the money supply in the economy can be declined and consequently the inflationary situation. At the same time, it should also be expected that the Central Bank will change the quantitative easing strategy for the economic growth and will also focus on increasing the saving rates in the economy (Lewis, 2013). It is because lower interest rates are affecting the return from the savings and due to this, it is declining continuously and consequently affecting the social welfare.

A rise in the interest rates should be expected from the Central Bank of England in order to increase the currency value and consequently will reduce the cost of exports and make the imports cheaper. It is because a higher interest rate will attract more investment in the economy and will increase the demand for the British Pound that will lead an appreciation in the value of the currency and will contribute to making the balance of payments positive (Brigo and Mercurio, 2013).

Conclusion

From the above discussion on the basis of different micro and macroeconomic theories, it can be explained that low-interest rates in the British economy over the last 7 years have a significant influence on the economic growth. It caused an increase in the economic growth, business investments and contributed to improving the living standards of the people in the economy. But, the British economy also faced a slight increase in the inflation rate, deficit in the balance of payment and a decline in the household saving rates, which influenced the long-term economic growth objectives of the government. So, it should be expected from the Central Bank of England that it should increase the interest rates in the current conditions so that the negative impact on the economic growth can be prevented.

References

Ball, M., Lizieri, C. and MacGregor, B. (2012) The Economics of Commercial Property Markets. UK: Routledge.

Barghini, T. and Pasquali, V. (2015) Household Saving Rates 2015. [online]. Available at: https://www.gfmag.com/global-data/economic-data/916lqg-household-saving-rates (Accessed: 12 March 2016).

Brigo, D. and Mercurio, F. (2013) Interest Rate Models Theory and Practice. UK: Springer Science & Business Media.

Canocchi, C. (2016) Britain on track for seven years of record low interest rates as global markets turmoil pushes back hike prospects. [Online]. Available at: https://www.thisismoney.co.uk/money/news/article-3399359/Britain-track-seven-years-record-low-rates-global-markets-turmoil-pushes-hike-prospects.html (Accessed: 14 March 2016).

Croucher, S. (2016) UK house prices: 'There is a real and growing risk of a sizeable property market correction. [online]. Available at: https://www.ibtimes.co.uk/uk-house-prices-there-real-growing-risk-sizeable-property-market-correction-1540657 (Accessed: 12 March 2016).

Global Price Guide. (2015) London property market continues to soften. [Online]. Available at: https://www.globalpropertyguide.com/Europe/United-Kingdom/Price-History (Accessed: 12 March 2016).

Houben, C.F.J. (2012) The Evolution of Monetary Policy Strategies in Europe. UK: Springer Science & Business Media.

Lewis, A. W. (2013) Theory of Economic Growth. UK: Routledge.

Means, G.C., Samuels, W.J. and Lee, L.X.H. (2015) A Monetary Theory of Employment. UK: Routledge.

Novales, A., Fernández, E. and Ruíz, J. (2014) Economic Growth: Theory and Numerical Solution Methods, 2nd edn. UK: Springer.

Peng, X. (2015) Financial Theory: Perspectives from China. USA: World Scientific.

Powell, R. and Powell, J. (2015) AQA A-level Economics, Book 1. UK: Hachette UK.

Sloman, J., and Jones, E. (2014) Economics and the Business Environment, 3rd Ed., Harlow: Pearson.

Trading Economies. (2016) United Kingdom Interest rate. [Online]. Available at: https://www.tradingeconomics.com/united-kingdom/interest-rate (Accessed: 12 March 2016).

Trading Economies1. (2016) United Kingdom inflation rate. [Online]. Available at: https://www.tradingeconomics.com/united-kingdom/inflation-cpi (Accessed: 12 March 2016).

Trading Economies2. (2016) United Kingdom household saving rate. [Online]. Available at: https://www.tradingeconomics.com/united-kingdom/personal-savings (Accessed: 12 March 2016).

Trading Economies3. (2016) United Kingdom balance of trade. [Online]. Available at: https://www.tradingeconomics.com/united-kingdom/balance-of-trade (Accessed: 12 March 2016).

Treanor, J. (2016) Interest rate rise judged unlikely as inflation increases only slightly. [Online]. Available at: https://www.theguardian.com/business/2016/feb/16/interest-rate-rise-judged-unlikely-as-inflation-increases-only-slightly (Accessed: 12 March 2016).

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