Explanation of Interest Rate [Virtual Economy]

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An explanation of the interest rate and how it is set by the Monetary POlicy Committee.

Interest Rate - Explanation

The interest rate can be considered as the price of money. If you want to borrow money it is the percentage over and above the original loan that has to be paid back. This makes the interest rate a vital tool of economic management. A large amount of economic activity (both consumption and investment) is done on borrowed money, and so if the interest rate is changed it will either encourage or discourage borrowing and therefore tend to increase or decrease economic growth.

The new Labour government in 1997 passed the control of interest rates over to the Bank of England. The government set it inflation targets that it is required to meet and it changes interest rates as it considers appropriate to achieve these targets. If it thinks there is a danger of inflation rising it may increase interest rates to discourage borrowing, and if it thinks inflation is falling it may reduce them. This decision about interest rates is made by the Monetary Policy Committee Look up Monetary Policy Committee in glossary of the Bank of England. This situation where the Bank set interest rates is known as 'operational independence' of the Bank of England.

There are many different interest rates in the UK, as interest rates will vary according to the amount of time money is tied up for (the longer term the investment the higher the rate on offer and vice-versa) and the riskiness of the investment (the riskier the investment the higher the rate is likely to be). Financial institutions will therefore usually set their rates from a base rate. All other rates for saving and borrowing will often then be expressed as an amount above or below the base.

Why not also have a look at the relevant theories about the interest rate, or have a go at the worksheet about it?