Interest Rates and Consumer Spending - Chain of Reasoning

In this short revision video we look at an analytical chain of reasoning explaining how higher interest rates might affect the growth and level of consumer spending in the UK economy.

Analyse how a rise in interest rates might influence consumer spending on goods and services.

Chain of analytical reasoning

• Interest rates rise when a central bank tightens monetary policy by raising their policy rate. In the UK for example, base rate has risen to 3%, the highest level since 2008.
• Higher interest rates can operate through the housing market to cause a slowdown or fall in consumer demand
• For example, an increase in mortgage interest rates will lead to a reduction in effective disposable income for home-buyers on variable rate mortgages. As a result, they will have less to spend.
• And if higher mortgage rates lead to a fall in house prices, then a negative wealth effect may happen. Perhaps the value of property drops below the outstanding mortgage leading to negative equity.
• Overall, higher interest rates causes consumer spending to get squeezed. This is expected to happen in the UK in 2023

Brief evaluation perspective

1. Many homeowners commit to fixed-interest rate mortgages for 2 years or more which means that they won’t be immediately affected by a rise in central bank interest rates. There will be a time lag before they have to renegotiate their mortgage deal.
2. For savers, higher interest rates boost their monthly income since they get a better return on deposits with banks
3. Higher mortgage rates might also cause house prices to drop which will improve affordability for first-time buyers.