Level 2 Business and Economics: External Influences
Who Decides on the Interest Rate?
We talk about 'the interest rate', but in reality there are many different interest rates. Each bank or financial institution will charge different interest rates depending on the type of loan, the duration of the loan, who the borrower is and so on.
Each bank will, however, have to think carefully when deciding its interest rate. Remember that a bank uses the deposits made by businesses and individuals to lend out to other businesses and individuals. It has to make sure that the interest rate it charges to borrowers is different to that it offers to depositors.
In addition to this, it also has to make sure that the interest it charges on the loans it wants to make is competitive with other banks and financial institutions. The banking system is quite complex but for our needs, we need to try to understand some basic things. At the top of the banking system is the Bank of England. The Bank of England acts as the banker to the government but also monitors the whole of the banking system.
Banks such as HSBC, Nat West, Lloyds TSB and Barclays have to manage their accounts in the same way that any other business does. There are millions of pounds flowing into and out of a bank every day; banks sometimes run short of funds and borrow money from the Bank of England. The rate at which the Bank of England lends to the banking system is called 'the interest rate' and is what determines the interest rates charged by the commercial banks like Barclays and Nat West.
Every month, members of the Bank of England Monetary Policy Committee (MPC) meet to decide on what 'the interest rate' will be. Banks and businesses watch the outcome of these meetings with interest (excuse the pun!)
Over the past few years, the Bank has not changed interest rates very much - if changes do occur, they tend to be by a quarter of a percent each time, either up or down. When the MPC do change interest rates, however, it does have an effect on the whole banking system and for businesses.
Changes in the Bank of England 'bank rate', which sets the pattern for interest rates throughout the economy. Source adapted from the Bank of England Web site.
If the Bank of England raises interest rates, banks tend to raise their interest rates as well. Businesses looking to take out loans will now have to pay more in interest than they would have done before; existing customers of the bank who already have loans might now find that their monthly repayments will rise.
Larger businesses that borrow millions of pound might be very badly affected by such changes. It is not all gloom and doom, however. Sometimes the Bank of England will reduce interest rates, which means that businesses will face cheaper loans both for new loans and for existing ones. If the Bank of England raises or lowers interest rates by 0.25%, there is no guarantee that a commercial bank such as HSBC or Lloyds TSB will either raise or lower its rates by the same amount - if at all!
Task 2
Jenny is one year into her loan agreement. The Bank of England announces a rise in interest rates by 0.25%. Jenny's bank sends her a letter a week later, telling her that the interest rate on the loan she has is now going to rise from 12.5% to 13%.
Using the same structure as in Task 1, calculate the difference in the monthly payments that Jenny now faces. Remember that Jenny is now one year into the agreement.