Impact of Low Interest Rate

Question: Demonstration of a clear understanding of the issues. Use of academic models. Clear focussed understanding of a topic. Critical analysis is an important test of the students ability to evaluate business economics concepts. Answer: Introduction Financial market faces challenges and difficulties as there is a variation in the rate of interest. The rate of interest is set by the central bank of a country. They decide whether to pump out money from the economy or to inject money within the economy. They alter the rate of interest in order to control money supply (Bankofengland.co.uk, 2016). The rate of interest has other impacts in the economy. This paper reviews the impact of interest rate with the help of one microeconomic framework and one macroeconomic theory. The interest of British economy has been low since 2009. The paper will focus to review the effect of low interest rate on the economy of United Kingdom. Low Rate of Interest in British Economy Interest rate is the charge of borrowing money. Before, analysing the effects of low rate of interest in United Kingdom, some common effects of low interest rate will be discussed. From the basic microeconomic theory, the change in the behaviour of individual firm or consumer can be analysed. Low rate of interest encourages the firms to hold more capital. In order to acquire more capital, the desire for loanable fund increases. In contrast, when the interest rate is high, less capital will be demanded and this will in turn lower the demand for borrowing. Hence, the demand for loanable money is inversely related to the interest rate. The curve is hence downward sloping. Similarly when the interest rate is higher, the lender finds it more attractive to lend fund, as he will get more in return. Therefore, the supply of loanable fund rises. When the yield rate is lower, the lender is less likely to lend fund. As a result of this the supply of loanable fund decreases. Therefore, the amoun t of loanable fund in directly related to the interest rate. The curve is hence upward sloping. The demand and supply curves for the available loanable money are represented in the following diagram. Figure 1: Demand and Supply of Loanable Fund Now, the paper will review macroeconomic effect of low rate of interest. Macroeconomic theory of interest rate develops from microeconomic idea. However, in this case, the economy is considered as a whole. Hence, the effect of interest rate can be described with the help of the macroeconomic model of aggregate demand and aggregate supply. The constituents of aggregate demand are: Consumption; government expenditure; investment and net trade surplus. This can be represented in the following equation: AD = Consumption (C) + Government Expenditure (G) + Investment + (Export Import). Investment is a negative function of interest rate. When the rate of interest rises, the investor does not invest much. When the rate of interest is lower, the investors are encouraged to invest. Since, investment is one of the components of Aggregate demand, therefore a change in interest rate indirectly affect the aggregate demand. When interest rate rises, the aggregate demand falls due to fall in the in vestment (Kiley 2012). Similarly, when rate of interest decreases the aggregate demand rises due to an increase in the investment. This can be represented in the following diagram. Figure 2: Effect of Interest on Aggregate Demand From the above diagram, it can be said that when interest rate is low, collective demand curve moves to the right. When the interest rate is high, aggregate demand curve moves to the left. Apart from variation in the aggregate demand, the yield rate also alters the price level in the economy. As observed in the above diagram, the low rate of interest leads to a rise in the inflation rate; and in contrast the high interest rate keeps price level low. Based on the above theories, the paper will analyse the impact of low interest rate on British economy over last seven years. Since, March 2009, the rate of interest at UK reached a record low level of 0.5% (Swanson and Williams 2014). This level is constant till the date. The following diagram represents the trend in rate of interest rate at UK economy., Figure 3: Interest rate in United Kingdom Source: Tradingeconomics.com, 2016 The economy of UK is affected by the low rate of interest in number of ways, as follows: Prior to global crisis, the interest rate was quite high in the economy of UK, and duo to the crisis, it has fallen significantly. During 2009, it cut back its rate of interest to a record low and since then GDP of UK has improved. This is due to the fact that, low interest has incresed the aggregate demand, as a result of which more goods and services are produced in the economy and thus GDP of the nation has increased. Hence it has stimulated the economic growth. This is repressented in the following diagram. Figure 4: GDP in United Kingdom Source : Tradingeconomics.com, 2016 Another impact of low interest rate in the economy of UK is that, housing prices at this country has risen rapidly. This is because the low interest rate made it more beneficial to buy assets. The rise in demand for assets has increased price of the assets faster than the increase in the wage of the UK economy. The low cost of borrowing has inflated the housing price bubble in UK economy (Ferrero2015). This has increased the wealth but it is troublesome for the first time buyer of houses. The low interest rate has decreased the return from nominal savings that is almost close to zero. Hence, people are less likely to save. But some rate of saving is necessary for future. The young generation tends to save less, which might affect them during the time of retirement. More over the low saving rate also affected the investment, as without a flow of savings investment cannot be funded (Balassa 2013). However, the low rate of interest helps the bank to improve its balance sheet and its capacity to spend. However, the low rate reduced the availability of mortgages. So even if the demand for borrowing is high but bank cannot provide loan due to lack of deposits (Sentance, 2015). The unemployment rate is inversely related to the rate of inflation. A low rate of interest leads to rise in the price level, which will reduce the unemployment rate. The unemployment rate started to decline in this economy. The Bank of England might revise the rate of interest if it thinks that the low rate of interest is causing the inflation rate to rise. Hence, to control inflation in the economy the central bank of this country can raise the interest rate. By reducing inflation rate the country can accelerate the unemployment rate. Hence, before taking such decision, the central bank will analyse its consequences. It was stated by the Bank of England that once the unemployment rate comes below 7% they will raise the rate of interest (Pwc.blogs.com, 2015). But in the British economy, in spite of low interest rate of interest the inflation is controlled. Rather the rate was negative during 2015. This situation is called deflation, where the output of the economy tends to fall (Blanchard, Furceri,and Pescatori 2014). Therefore, to maintain a growth of the economy, the Bank of England will continue to keep its interest at a low level. Moreover, if the Bank of England raises the interest rate for the fir st time since the economic crisis, it is expected to give an adverse shock to the confidence of the British economy. The low rate of interest encourages the consumer to buy more, this will increase the import of the nation, and this will lead to fall in current account. It is evident that the low rate of interest has adversely affected the current account of the British economy, which is represented in the following diagram. Figure 5: Current Account in United Kingdom Source: Tradingeconomics.com, 2016 The current account has been negative in the economy of UK. This negative balance can be considered as a contribution of the low rate of interest. Hence, in this respect it can be expected from the central bank of this nation, to increase the interest rate. Moreover, the lower interest rate causes the currency of the country to depreciate; this makes the export more competitive. The higher is the rate of interest, the stronger will be the currency. In contrast, the lower interest rate weakens the currency of the country. Hence, if the Bank of England wants to depreciate the currency it can lower the rate of interest and if it wants to appreciate its currency, it will raise the rate of interest. The higher value of the currency will attract the foreign investment, as investor would like to invest in a country where the currency is strong. Similarly, lower interest rate will discourage the foreign investors as the domestic currency is not strong. Therefore, in some cases, the low inter est rate attributed positively in the economy of UK, and in some cases, it faces difficulties. Therefore, the Bank of England will act according to the severity of the effect. Conclusion The above discussion focuses on the microeconomic and macroeconomic effects of low rate of interest. The low rate of interest has been persisting in the UK economy for considerable years. It has affected the British economy in several ways. The role of bank of England has been discussed in controlling the impact of low interest rate. It is the only governing body that can directly change the rate of interest and control the economic performances (Chan, 2015). References Balassa, B., 2013. The effects of interest rates on savings in developing countries.PSL Quarterly Review,43(172). Bankofengland.co.uk., 2016.How does monetary policy work? | Bank of England. [online] Available at: https://www.bankofengland.co.uk/monetarypolicy/pages/how.aspx [Accessed 21 Mar. 2016]. Blanchard, O.J., Furceri, D. and Pescatori, A., 2014. A prolonged period of low real interest rates?.Secular stagnation: facts, causes and cures, p.101. Chan, S., 2015.Who sets UK interest rates?. [online] Telegraph.co.uk. Available at: https://www.telegraph.co.uk/finance/bank-of-england/11755220/Who-sets-UK-interest-rates.html [Accessed 21 Mar. 2016]. Ferrero, A., 2015. House price booms, current account deficits, and low interest rates.Journal of Money, Credit and Banking,47(S1), pp.261-293. Kiley, M.T., 2012. 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