Effects Of Low-Interest Rates On The UK Economy

Effects of low rate of interest

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In the case of UK economy, the rate of interest was very low from the past seven years. The lower rates of interest will encourage borrowing which will lead to attracting the investment as well as the citizens spending (Aspromourgos, 2011). The aggregate demand of UK citizens become higher and thus economic growth in the UK has taken place. However, the inflationary pressure can be seen due to a rise in the aggregate demand. It can be argued that the rate of interest must stay at the very bottom level in the current year. Thus, Central Bank of England should take some policies to increase the rate which will set the standard for overdraft, mortgage and loans.

This report will discuss the effects of low-interest rates in the context of UK economy and the possible measures taken by Central Bank of England to control the situation.

There are some situations which will arise due to the low rate of interests. The effects are-

Firstly, the lower rates of interest give a lower yield from saving. Thus, the incentive to save will be lower which attracts the customers spending rather than the holding on to money.

Secondly, the lower rate of interest makes a cheaper borrowing cost in the UK. This situation encourages the citizens, as well as firms, take the loans to finance investment as well as greater spending (Gerlach and Lewis, 2013).

Thirdly, the price of assets increases due to the low-interest rates. Thus, purchasing the assets are attractive for the UK citizens. Thus, the price of houses had increased and hence there is a rise in the wealth. This will encourage the spending among customers (Bolt et.al., 2015).

Fourthly, when the rate of interest is lower, there is a reduction in the mortgages’ monthly costs. Thus, more disposable income has been seen among UK citizens which raise the customer spending.

Lastly, as the rate of interests is low from last seven years, then UK citizens save relatively lesser amount. Thus, there is a fall in the value. Fall in the rate of exchange makes the import costlier which affect the AD (Bhattarai, 2011).

Macroeconomic Model

The model of AD shows AD= C+I+G (X-M). As the rate of interest is lower, the components like C, I, (X-M) have increased (Blanchard and Johnson, 2013).

Figure 1: UK Interest rate

To enhance the growth in the UK after recession UK government body were cut the rate of interest. The below figure will help to understand the effects of lower interest rate.

Figure 2: AD-AS model

Source: (Blanchard and Johnson, 2013).

Lower interest rate increases the aggregate demand from AD to AD2. There will be no change in AS curve. Previously, the real GDP was Y1 and after the shift in the AD, the real GDP increases to Y2. It shows that there is a higher economic growth in the UK. Inflation rises as AD increases (Mankiw, 2012).

The above study has shown that from 2007 the interest rate is very low which has proved to be partially successful in affecting the high level of growth in the UK.

Table 1: Interest Rate in the UK (WorldDataBank, 2016).

Series Code	Country Name	Country Code	2007	2008	2009	2010	2011	2012	2013	2014
FR.INR.RINR	United Kingdom	GBR	2.574535317	1.764719688	-1.375897334	-2.532556408	-1.563418231	-1.107699076	-1.456129255	-1.186293701

When the interest rate is lower, that is, from 2008 to 2014, it will have a different impact on society’s various groups. The homeowners, borrowers and the mortgage holders get privilege from the lower interest rate in the UK. Thus, these people will spend more money. However, savers face some negative impact. The retired person of UK have lower disposable income from the savings and hence the spending surely be lower. In the UK, a higher proportion of people depends on their saving. The lower rate of interest reduces the income of them. The UK is known as a region of borrowers. Thus, the level of debt mortgage is higher. Therefore, the low level of interest rate has a greater impact in the United Kingdom. Thus, it can be said that EU nations have a tendency to depend on rent rather than buying. The lower interest rate will also affect the current account of trade. As it attracts the spending of the citizens, there is a noticeable rise in the import spending. Thus, the current account has been deteriorated. It also causes an exchange rate depreciation in UK economy. Thus, the export is competitive than before as well as elastic demand can be seen in the UK. This incident will lead to an improvement in UK’s current account. Thus, the effects are little confusing for the researcher.

The service sectors of UK has been affected adversely due to the continuous slowdown of interest rate. Lower rate creates turmoil in the financial sectors which will lead to the lowest growth from the past three years. The rate of interest is low historically from the past 7 years and the figures have given the assurance to the policymakers of the bank of England that costs of borrowing will be low without a rise in inflation. The snapshot of service sectors has shown that the different business actions in the UK cover the insurers’ hairdressers and has expanded at a very slow rate from 2013 March when UK economy was a fragile economy and recessions came into place.

In this situation, the Central Bank of England will try to modify its monetary policy to bring monetary stability in the UK by bringing inflation stability in the economy, and also controlling the social and economic consequences (Kirby, 2013). There are some factors which should be taken into account to manage the interest rate.

In the meetings of setting or changing the rate of interest, the policymakers should know every information about the UK economy. While taking the decision the bank members should be taken into account

Impact of lower interest rate in the UK

The rate of GDP growth and output gap size should be taken into account. Hence, the bank will set the monetary policy in a manner by which the bank can control the AD of UK economy and make it productive in nature.

It includes the withdrawal of equity from the market of housing as well as the credit card lending data which should support the demand of the consumer.

Both are very important for UK economy in the determination of wealth of household. The monetary policy should not have any target officially for the housing price inflation annually.

The wage inflation will lead to a cost-push inflation. Thus, the bank should be careful about the wage rate.

To control this situation, the contractionary monetary policy may be used by the central bank of England. This policy will help to finance the slowdown situation of UK economy. It is basically used in the money supply reduction as well as spending in the UK. The Central Bank can use this policy by increasing the interest rate, raising the requirements of reserves and by reducing the supply of money (McTaggart et.al., 2012).

As the rate of interest is very low from last 7 years, this policy may be used to enhance the rate. After assigning a high-interest rate, the government as well as other banks will start borrow at that rate, however, to build the level of money, the other banks will also lend the interest rate which will be higher. When the Central bank have imposed the higher rate, other banks also start following it (Gordon, 2012). Thus, the borrowing will be lower by the consumers. Thus, inflation will be also reduced from the UK economy. When interest rate increases, the savings will be raised and retired individuals will start spending more than this slowdown situation.

The central bank of can also increase the requirements of reserves over the other commercial banks to monitor the withdrawals on a regular basis. When the requirement is greater, the banks will borrow at a lower rate from the citizens. Thus, spending will be decreased automatically which will control the demand pull inflation (Escolano et.al., 2014).

The central bank can reduce the supply of money directly along with indirectly. With a higher demand, the policy will enhance the exchange rate. Thus, there will be an increase in the rate of import and decrease in export. The circulation of money will be managed the Central Bank of England (Olugbode et.al., 2013).

Conclusion

In this study, the researcher has shown that interest rate in the UK has fallen down from last seven years. The various effects of low-interest rates have been discussed by using microeconomic and macroeconomic theories. Basically, it has risen the AD. Thus, Central Bank of England should perceive the monetary policy to control demand-pull inflation as well as slowdown situation.

References

Aspromourgos, T. (2011). CAN (AND SHOULD) MONETARY POLICY PURSUE A ZERO REAL INTEREST RATE, PERMANENTLY?. Metroeconomica, 62(4), pp.635-655.

Bhattarai, K. (2011). The impact of the exchange rate and money supply on growth, inflation and interest rates in the UK. IJMEF, 4(4), p.355.

Blanchard, O. and Johnson, D. (2013). Macroeconomics. Boston (Mass.): Pearson.

Bolt, W., Demertzis, M., Diks, C., Hommes, C. and Leij, M. (2015). Identifying booms and busts in house prices under heterogeneous expectations. [Luxembourg]: [Publications Office].

Escolano, J., Kolerus, C. and Lonkeng Ngouana, C. (2014). Global Monetary Tightening. Washington: International Monetary Fund.

Gerlach, S. and Lewis, J. (2013). Zero lower bound, ECB interest rate policy and the financial crisis. Empir Econ, 46(3), pp.865-886.

Gordon, R. (2012). Macroeconomics. Boston: Addison-Wesley.

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

Mankiw, N. (2012). Macroeconomics. New York: Worth.

McTaggart, D., Findlay, C. and Parkin, M. (2012). Macroeconomics. Frenchs Forest, N.S.W.: Pearson.

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.

WorldDataBank. (2016). [online] Databank.worldbank.org. Available at: https://databank.worldbank.org/data/reports.aspx?source=2&country=&series=FR.INR.RINR&period=#