Monetary Policy - The Impact on the Rest of the Economy
The effects of changing interest rates on the macroeconomy have already been discussed on the previous pages, but it is also important to consider the effects at a micro level. If interest rates are cut then this should increase the level of investment, but by how much? The amount by which investment increases depends on the interest elasticity of demand for investment. If investment is interest elastic then there will be a large increase in investment following an interest rate cut. This is shown in the first figure below. If investment is, however, interest-inelastic then there will be a much smaller increase, as shown in the second figure.
The effect of an interest rate cut on savings also has to be considered. Lower interest rates will tend to discourage people from saving so much which may create a shortage of funds for banks to lend to firms for investment. For this reason governments will often try to encourage savings by offering tax advantages. An example of this is the ISAs (Individual Savings Accounts) that were introduced in April 1999.
Many economists argue that changes in the money supply will have an impact on inflation. Monetarists and classical economists use the Quantity Theory of Money to back up their argument that excess money supply growth will feed through to increases in prices. There is much more detail on this in the theory section of the Library. Use either the side panel (3rd floor) or the navigation bar at the top of the page to get there.