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Monetary Policy - Monetary Policy Committee

Theory 1 - Monetary Transmission Mechanism - what are the links between the interest rate and inflation?

Stage 2

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Stage 2 of the transmission mechanism is the way in which changes in markets then affect the level of spending in the economy. All things being equal (which they rarely are in economics!) we would expect an increase in interest rates to reduce spending, but why? Let's look in turn at the effects on individuals and firms.

Individuals

Individuals are affected by interest rate changes in various ways, but there will tend to be three direct effects:

1. The first effect happens because they will find that they now face different interest rates on their savings and borrowing. An increase in the interest rate will mean that their disposable income is likely to have fallen if they are net borrowers. The most obvious impact of this is through the mortgage rate, given that 80% of personal debt in this country is loans secured on houses. Higher mortgage payments mean that people have less money left to spend on other things and so spending is likely to fall.
2. The second effect is through the effect of interest rate changes on people's wealth. People may have their wealth in the form of houses, shares or some other financial asset. However, whatever the asset, an increase in interest rates is likely to mean that the value of these assets will fall. That makes people feel less well-off and so their spending is likely to fall as well.
3. If the exchange rate changes as a result of an interest rate change, then this may affect the pattern of spending. Say that an increase in the interest rate leads to an appreciation of the exchange rate. This will make imports appear relatively cheaper, and exports more expensive. This may cause people to switch their spending from domestically produced goods to overseas imported goods. They will probably do this unwittingly, and are simply reacting to price changes. However, the impact of this is that UK firms are now facing less demand. So although the level of spending overall hasn't changed, the level of spending on UK goods has fallen.

Of course some individuals will be affected in different ways depending on their circumstances. However, the MPC can only set one interest rate and so have to look at the whole picture and cannot take account of individuals whose circumstances may be different from average.

Firms

All firms will be affected by interest rate changes differently. The exact effects will depend on many things including the size of the business, the amount they have borrowed and where they borrowed it from and the nature of the business. Generally though we would expect an increase in interest rates to affect the firm adversely.

Like individuals, many firms will be net borrowers. They tend to borrow to fund investment and many will also have overdrafts or other short-term borrowing to help their cash flow. If interest rates increase they will find that the cost of their borrowing has increased. This will reduce the profitability of the firm and may make them more reluctant to increase employment. It will also adversely affect new investment projects. Firms will only make an investment if they make a return reasonably above the rate of interest on their borrowing. If the interest rate increases, fewer investment projects are now viable, and so investment will tend to fall.

Of course, firms who have not borrowed much and have a significant amount of cash will relish interest rate increases as they can now make a higher return on their money. However, it would be safe to assume that firms like this will tend to be in the minority, and the main effect of an interest rate increase will be to reduce investment.

Firms will also be affected by exchange rate changes. Many firms source a lot of their raw materials from overseas and the cost of them tends to be fixed in the short-term. An appreciation of the exchange rate will then adversely affect them for a while compared to firms in other countries. However, official interest rate changes are only one small factor in the determination of exchange rates.

MPC decisions on interest rates will also affect business confidence. Firms have to plan some time ahead for their investment, and so have to look carefully at what they think will happen in the future. The MPC's decision gives a clear indication of their view on the future, and this may affect what firms think as well. The exact effect will depend on how strongly the firm holds its views.