External Environment: Interest Rates (GCSE)

An interest rate is the cost of borrowing money or the return for investing money.

For example, a bank charges interest on amounts loaned out or on the balance of an overdrawn bank account.

A bank will also pay interest to the owner of an account with a positive balance.

Interest rates vary depending on the type and provider of borrowing.

Introduction

The base interest rate in the UK economy is set by the Bank of England. Each month, the Monetary Policy Committee of the Bank of England to decide what the base rate should be.

Since 2009 the base interest rate in the UK has been kept a historically low level of 0.5%.

The base interest rate set by the Bank of England affects other interest rates in the economy because it is the rate at which banks can themselves lend from the Bank of England.

In theory, a lower base rate will lead to lower interest rates on borrowings paid by businesses – but not necessarily.

The effect of a change in interest rate will be affected by whether borrowing is at a variable or fixed rate:

With a variable rate, the interest charged varies in relation to the base rate.

A fixed interest rate means that the interest cost is calculated at a fixed rate – which doesn't change over the period of the credit, whatever happens to the base rate.

Effects of Changes in Interest Rates

The effect of a change in interest rates will depend on several factors, such as:

• The amount that a business has borrowed and on what terms
• The cash balances that a business holds
• Whether the business operates in markets that depend on consumer spending

Let's look at the third factor listed above to examine the implications a little more closely.

Consider the example of households and consumers who like to pay for their goods and services using borrowing such as credit cards or a bank overdraft or loan. Also think about households who have substantial balances outstanding on a mortgage used to finance a house purchase.

An increase in interest rates will mean that the cost of borrowing rises.

In theory, a higher bank base rate will mean that credit card companies such as Visa and MasterCard will also raise the rate they charge borrowers on amounts that are outstanding.

A higher interest rate will also mean an increase in the monthly mortgage payments that are made by home-owners who have mortgages which are charged at a variable rate.

In both cases, the disposable income of consumers and households will fall.

The monthly mortgage payment might rise from say £500 to £550, which means that the household has £50 less disposable income available to spend or save.

If consumers and households think that the rise in interest rates is temporary or short-term, they may simply continue to spend as before. In this case, there will be little effect on demand. However, it might also prompt them to cut back on spending, which would result in lower demand.

Some businesses operate in markets which are very sensitive to changes in interest rates. These markets often involve goods and services where the purchase is financed by debt and where the price paid is relatively significant compared with the customer's income. For example:

• Housing (mortgages)
• Motor vehicles
• Holidays
• Major purchases of consumer goods – e.g. new kitchen equipment, audio-visual systems