External environment - Role of the Bank of England
Theory 2 - Effects of interest rates - how do they affect demand?
As we have described elsewhere, the key method to control inflation is now the manipulation of short-term interest rates (by the Monetary Policy Committee). These are changed, if necessary, each month to keep inflation under control. If the MPC think that demand is set to rise too fast, then they will increase the rate, but if they think demand is growing at too slow a rate, or perhaps even falling, then they will reduce the rate. But how does this change in the interest rate affect the demand for goods and services?
The mechanism by which changes in the interest rate affect demand is called the transmission mechanism and it acts on demand both internally (within the UK) and externally (demand from overseas).
Internal demand changes
- Consumer borrowing - many consumers fund their purchases by borrowing. This may be on personal loans from the banks or it may be on credit cards. Either way, it will become less attractive to borrow with higher interest rates as the repayments will be greater.
- Consumer debt - because of existing levels of borrowing, higher interest rates will mean higher repayment costs (often called debt servicing). This will leave consumers with less surplus income to spend and so will lead to a fall in demand.
- Mortgage debts - most people have to borrow to buy their house and the payments on the mortgage they take out to do this will vary with the rate of interest (unless they have a fixed rate mortgage). Higher interest rates will mean higher mortgage repayments and this will cut people's disposable income leading to a fall in demand.
- Expectations - an increase in interest rates may act as a signal to people to have less confidence in the future path of the economy. This may mean they delay purchases as they become more concerned about possible higher unemployment or a fall in their income.
- Asset prices - higher interest rates may mean a fall in the prices of some assets. This may be shares or gilt-edged securities (government borrowing) or perhaps even houses. If asset prices fall, this may make people feel less wealthy and they may cut back on their spending in response.
External demand changes
- Exchange rate - an increase in interest rates may lead to an appreciation in the exchange rate. This will make exports less competitive overseas and may therefore lead to a fall in demand for UK exports. This will also mean a fall in demand for goods and services in the economy.
All these factors mean that companies need to watch interest rates carefully to assess the likely impact on the level of demand for their product or service.
