Unit 2 Macro: Interest Rates and Income Inequality

Changes in interest rates on loans and savings deposits across an economy can have - over time - a sizeable effect on the overall distribution of income and wealth in a country. Since March 2009 official policy interest rates in the UK economy have been held at an historic low of 0.5%.

New research from the Bank of England indicate that this lengthy period of ultra-low returns for savers has caused a dramatic redistribution of income away from savers towards borrowers, especially those on variable-rate mortgages. The Bank of England suggest that savers have lost more than £40bn because of low interest rates since the spring of 2009, but those losses are mirrored by dramatic gains, amounting to more than £50bn, for mortgage borrowers who have paid less in interest on their loans during the same period. This video from BBC news provides some extra background.

Consider the effect of a general but significant fall in interest rates throughout an economy

The real income of savers: If the rate of interest paid on savings falls below the rate of inflation, then people with positive net savings will see a reduction in their real incomes. This has become a major policy issue since 2008-09 with interest rates on deposit accounts collapsing in the UK. Rising inflation and falling interest rates have dealt a double-blow to millions of savers many of whom are older and reliant on savings as a source of income. The return is even lower when we consider that most savers pay 20% tax on any interest.

The disposable incomes of mortgage-payers: If interest rates fall, the income of home-owners who have variable-rate mortgages will increase – leading to an rise in their purchasing power

Interest rates, house prices and wealth: Many factors affect the average level of house prices but when the cost of a mortgage falls, standard theory predicts that the demand for housing will expand driving property values higher. This increases the net financial wealth of people who own property but makes it more difficult for lower-income families including many young people to find the money to afford to purchase a house or flat.

In summary - when interest rates fall, there is a re-distribution of income away from lenders (who receive less) towards those with variable rate loans. People with positive net savings also stand to lose out from big cuts in interest rates. Little wonder that the Governor of the Bank of England gets many letters of complaints from pensioners when interest rates are cut or remain low for long periods of time!