Effects of Low Interest Rates on British Economy

Question: Describe about effects of low interest rates on british economy. Answer: Introduction Economics is the study of wealth which is created when goods and services are produced. The commodities are produced making use of resources which are scarce. There are resources like land, labour, capital and entrepreneurship which are used to make products. Further, there are two branches of economics- macroeconomics and microeconomics. Macroeconomics is involved with the study of economy of a country in totality. The concept of macroeconomics is concerned with issues like poverty, unemployment, national income, inflation, monetary policy of the central bank etc. On the other hand, microeconomics is concerned with issues facing a firm or an industry. An enterprise has to decide what to produce, what quantity to produce, at what rate of interest the additional capital would be procured, how much to pay to the labour etc. The study of both Macroeconomics and Microeconomics is important for the welfare of the people of a country. The Central bank of a nation, through its monetary policy, tries to safeguard the interests of people of the country by making various policy decisions. The central bank of a country usually is the supplier of money in the economy. The bank is the only authority in the country which can print the countrys currency. The central bank lends money to other commercial banks in the country at a certain rate of interest (Bank of England, 2016). The commercial banks in turn lend money to the industry and individuals. Industry uses this money for carrying out business activities. The individuals use this money to buy different goods. The central bank charges a rate of interest on the money lent by it. Similarly the commercial banks also charge a rate of interest on the money lent by them. The central bank can make the cost of loans higher by increasing the rate of interest charged. When the rate of interest goes up, there is a fall in the demand of money. Thus the central bank can influence t he level of activity in the economy through its monetary policy of increasing or decreasing the interest rates on the money lent by it. Effects of Low Interest Rates on British Economy There are several reasons why Central Bank of England has continued to keep the interest rates down (Bank Of England, 2016). The industrial activity in the country has become better. But there are many major economies in the world where there is no or very little growth of the gross domestic product. There is lesser demand for goods and services all over the world. In the modern world, the economies of different countries are interconnected. If there is a recession in one big country, many other countries get affected. The Central Bank of England wants that there should be more industrial activity in the country so that more people get employed. This in turn would bring more prosperity in the country. The lowering of interest rates means that cost of production for the industry goes down (Hong and Yogo, 2012). Interest on loans taken from banks to finance working capital is a cost for the industry. There are companies in United Kingdom exporting goods to other countries. The exporters of goods can now offer the goods to foreign consumers at lower rates. This helps them to beat the international competition. On the other hand, the exporters have the option to sell their products at the same rates as before but use the savings in interest costs to invest in other activities like research and development of better products. This would lead to more earnings in future through improved demand for their products. The Central Bank has kept the interest rates lower so that the industry borrows more money at a cheaper rate (Delis and Kouretas, 2011). According to the Classical Theory of interest, money is demanded by a business organization as it is a form of capital. This capital is used to buy different things like machinery, furniture, stock etc. A business firm would borrow money to an extent where the rate of interest is lower or equal to the marginal productivity of the business. Further the rate of interest is determined by the demand and supply of capital. If the rate of interest is lowered, the demand for capital would increase. Therefore if the rate of interest is lowered by banks, firms would borrow more. Lower interest rates for the industry means lesser costs for the industry in the form of interest (Hein and Schoder, 2011). This acts as an incentive for the industry to produce more. More production has a multiplier effect in the economy. People get jobs and their purchasing power g oes up. They also demand more goods. As the money becomes cheaper, the common people borrow more and also spend more. This also leads to more economic activity in the country (Ramey, 2011). When the Central Bank of a country lowers the rate of interest, it leads to general lowering of interest rates in the economy. The companies can borrow money from people through the instrument of debentures at lower rates. As interest rates on money lent by commercial banks also go down, people borrow more and demand for goods by people also goes up. In this case companies borrow money from people in the form of debentures and use the money for growing their business and producing more. All this leads to growth in the economy. The rate of inflation in United Kingdom is low (Boyer and Melvin, 2016). When the Central Bank lowers the rate of interest, people borrow more from the commercial banks. This increases the supply of money in the economy. Sometimes more money in the economy leads to inflation. But the inflation rate in United Kingdom is not very high. So, the Central Bank can afford to keep the rate of interest lower. There has been a fall in the international oil prices (Dogrul and Soytas, 2010). This has led to low inflation rate. If the price of oil goes up, there is a general increase in the prices of goods. The transportation costs increase. But the international oil prices have been falling steadily. This has helped to keep inflation in check in United Kingdom. The Central Bank of England has been following the policy of keeping the interest rates low. One of the major objectives of this policy is to support the industrial activity in the country. When business organizations want to increase their production, the enterprises have to employ more people. As there is an increased demand for workers, more people get employment (Farmer, 2012). Further, the workers are in a better position to demand more wages. More skilled and educated employees also expect their salaries to rise as the companies grow their businesses. This kind of growth in the economy is more inclusive. It is not only the owners of business but also the employees belonging to the lower income segment, who benefit from increased industrial activity. The low interest rates promote entrepreneurship in the country. There are people who want to start their own businesses. If the interest rates on the bank loans are low, such persons get encouraged to borrow money from banks. There is an environment created which supports small businesses also. Employment opportunities are generated when new businesses are set up. There are businesses which start at a small scale but grow into big business concerns (Lam, 2010). One of the adverse effects of low interest rates is that people do not want to increase their savings in the form of cash. They want to quickly part with their money borrowed from banks (or earned by them) and purchase goods and make other investments in shares, gold, etc where they feel returns would be more. When interest rates for money go down in the economy, the value of the currency goes down. Individuals want cash from banks at lower rates but spend this cash to buy other assets. In such cases people are not encouraged to save money in the form of bank deposits, which give them lesser returns as the interest rates are lower. They sometimes indulge in speculative investments to earn more (Farmer, 2012). This can be counterproductive. According to theory of interest given by Keynes, interest is the price charged by an individual for parting with liquidity. A person wants to keep cash to meet requirements of goods needed for survival. After meeting the basic needs, there is cash left with the person. The individual would lend this cash to someone only if it gets good returns in the form of high interest. Otherwise the person would invest cash available in some other form of asset. It can be understood that the rate of interest affects the movement of funds in an economy. The rate of interest depends on the demand for liquidity and supply of liquidity. Cash empowers an individual or a firm to acquire other products. This capacity of cash adds value to it. When a person lends cash to another individual, the former is giving up the ability to buy other things also with that cash amount. Conclusion Central Bank of England is expected to continue with its policy of low interest rates in the near future. The efforts of the bank to give incentives to the industry seem to be paying off. The economy of the United Kingdom shows no sign of slipping into a recession. In fact, the economy has been growing, though at a low rate. The employment figures for the economy as a whole have been encouraging. As the economy becomes stronger in future, it can be expected that the central bank would take steps to bring more value to the currency. In other words, interest rates in the economy would go up. This would encourage people to save more. Further the value of the British currency would become better in relation to other currencies of the world (Ehrmann, Fratzscher and Rigobon, 2011). References Bank Of England (2016) How Does Monetary Policy Work. Available at: https://www.bankofengland.co.uk/monetarypolicy/Pages/default.aspx (Accessed: 16 March 2016) Bank Of England (2016) Monetary Policy. Available at: https://www.bankofengland.co.uk/monetarypolicy/Pages/default.aspx (Accessed: 16 March 2016) Boyes, W. and Melvin, M. (2016) Macroeconomics. 10th (edn.) Cengage Learning, United Kingdom. Delis, M. and Kouretas, G. 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