ChainWhat it assumes · how to break it
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The Monetary Policy Committee raises Bank Rate, for example from 4% to 5%.
1
As a result, commercial banks pass the rise on: interest rates on mortgages, loans and credit cards go up, and savings accounts pay more.
transmission mechanism
transmission mechanism
Assumes: Banks pass the rise on quickly and in full.
But: Most UK mortgages are fixed for two to five years, so a large part of the effect only arrives as those deals expire.
2
This means households with variable or expiring mortgages pay more each month, so discretionary income falls, and saving becomes more rewarding than spending. Consumption falls.
discretionary income
discretionary income
Assumes: Households are net borrowers.
But: Savers, often older households, receive more interest income and may spend more, which offsets some of the fall.
3
At the same time, borrowing to invest costs more, so fewer projects earn a return above the cost of the loan. Investment falls.
rate of return on capital
rate of return on capital
Assumes: Investment is sensitive to interest rates.
But: Investment depends more on expected demand and business confidence, and firms using retained profit do not need to borrow.
4
Since consumption and investment are components of aggregate demand, AD shifts to the left.
AD = C + I + G + (X − M)
AD = C + I + G + (X − M)
Assumes: Nothing else offsets the fall.
But: If government spending rises or export demand is strong at the same time, AD may barely move.
5
As a result, firms sell less and cut output to match the lower demand.
output
output
Assumes: Firms expect the fall in demand to last.
But: Firms that expect a short dip may run down stocks rather than cut production.
6
Since labour is a derived demand, firms need fewer workers to produce the lower output.
derived demand
derived demand
Best link to attack
Assumes: Firms cut jobs rather than hours.
Assumes: Firms cut jobs rather than hours.
But: In a tight labour market firms may hoard skilled workers, cutting overtime or hours instead because rehiring later is costly.
7
This means firms freeze hiring and make some workers redundant, so demand-deficient unemployment rises.
cyclical (demand-deficient) unemployment
cyclical (demand-deficient) unemployment
Assumes: There are few vacancies for those who lose jobs.
But: If vacancies are high, workers who lose their jobs find new ones quickly and unemployment rises only a little.
End
Unemployment rises: the cost in jobs of using interest rates to cut inflation.
Link to the Phillips curve: in the short run, lower inflation tends to come with higher unemployment.
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Questions this answers
- Explain how an increase in interest rates might increase unemployment.
- Discuss the possible conflict between low inflation and low unemployment.
- Assess the impact of a rise in Bank Rate on the UK labour market.
Diagram
AD/AS: AD shifts left so output falls further below full employment; or labour market: labour demand shifts left.
Reverse and related
Bank Rate cut → unemployment falls.