INTEREST RATE AND THE ECONOMIC CLIMATE

Interest Rates

The Interest Rate is the price changed by a bank per year for lending money or for providing credit. Individual banks decide for themselves about the rate they will charge on their credit card or for the overdrafts they provide. But they are usually influenced by the interest rates that the bank of England charges the banks for borrowing money: the bank rate. This is set each month by a committee of the bank of England.

The Bank of England committee is asked to set interest rates at a level which should ensure that UK prices rise by around 2% a year. If the committee members decide that the economy is growing so strongly that prices may rise faster than 2%, it will increase interest rates. Then people will feel worried about borrowing more (because of the higher repayment cost) and may cut their spending. This should help discourage firms from increasing their prices.

For firms, the level of interest rates is very important because:

· It affects consumer demand, especially for goods bought on credit, such as houses and cars; the higher the rate of interest, the lower the sales that can be expected

· the interest charges affect the total operating costs (i.e. the higher the interest rate, the higher the costs of running an overdraft, the therefore the lower the profit)

· the higher the rate of interest, the less attractive it is for a firm to invest money into the future of the business; therefore there is a risk of falling demand for items such as lorries, computers and factory machinery.

If interest rates fall, the opposite effects occur, to the benefit of both companies and the economy as a whole.

Interest Rates

This Describes: 1. The cost of borrowing

2. The reward that depositors get from financial institutions

Do interest rates have a macro-economic impact?

Yes. This can be seen in the two different cases.

· When interest rates go high, investors at all sectors of production will be discouraged to borrow. Eventually, the supply of money in the economy will be less which may result to less economic growth, unemployment and less disposable income and discretionary income.

· When interest rates become lower, investors at all sectors of production will be encouraged to borrow. Eventually, the supply of money in the economy will be high leading to high economic growth, and more disposable income and discretionary income due to high employment.

Do interest rates have micro-economic impact?

Yes. In particular, small and weaker businesses would be vulnerable to any increase in interest rates.

This would effect on:

1. Finance: In general, small businesses find it difficult to raise finance. However, any increase in interest rates will make it more difficult for these businesses to finance their activities. Eg. buy a machinery, etc.

2. Stock: Businesses might find it better to reduce the level of stock, so that the money that was tied up in stock could be sued to finance short term requirements.

3. Cost: The cost of borrowings would be high leading to less profitability. On the other hand, the cost of the other factors of production will be high, eg. Keeping stock where demand is less.

4. Revenue: As a result of high interest rates, customers will be more attracted to savings than spending. They are also less likely to borrow money to spend and consequently, it may reduce sales for the business.

5. Competitiveness: In the domestic market, smaller and weaker firms would lose their competitiveness (in terms of price), as their costs are maximized. However, in the foreign market, both small and big businesses will be harmed, as prices in the international market tend to be lower. [ higher interest rates might cause an appreciation of the exchange rate à expensive exports and cheaper imports]