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Theory 3 - Theories - Government Policy - External Environment - Business bank - Virtual Bank of Biz/ed

External environment - Government policy

Theory 3 - Effects of interest rates - how interesting is this for business?

The key method of controlling inflation is now the manipulation of interest rates. Interest rates are reviewed each month by the Monetary Policy Committee (MPC) of the Bank of England. If they feel that inflation is in danger of rising, then they will increase interest rates or vice-versa.

These interest rate changes may have a variety of effects on businesses and so they need to watch them carefully. Let's have a look at the possible impact of a rate rise:

  • Higher debt repayment costs - many businesses borrow for both long-term investment finance (perhaps for expansion of other investment) but also to meet their short-term needs for working capital. Higher interest rates will mean that the cost of this borrowing will be higher. The more highly geared (the proportion of loans to share capital) the company is, the greater the impact of this is likely to be.
  • Lower consumer spending - a large proportion of consumers have debts. These may be credit card debts, personal loans or perhaps their mortgage. Whatever the nature of the debts, higher interest rates will mean that they have to pay higher interest charges and this means that they are likely to cut back their spending. This will particularly affect businesses that sell products that are income elastic (sensitive to changes in income).
  • Less investment - higher interest rates mean that fewer investment projects will be worthwhile. The cost of investment has increased and the value of future returns (the discounted cash flow) has decreased. This might make some investment projects at the margin less worthwhile and firms may cut back. This will have adverse effects for the whole economy if it is sustained.
  • Higher exchange rate - an increase in the interest rate may push up the value of the exchange rate on the foreign exchange market. This will raise the relative price of exports and make it more difficult for firms to export. However, if they buy supplies from overseas, the cost of these imports will fall and this may reduce their costs.