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The Monetary Policy Committee raises Bank Rate, for example from 4% to 5%.
1
As a result, yields on newly issued gilts rise, because the government must match the higher returns available on other assets.
gilt yield
gilt yield
Assumes: Gilt yields follow Bank Rate.
But: Long-term yields depend on expected future rates and inflation, not only on today's Bank Rate.
2
This means the cost of issuing new debt and refinancing maturing gilts rises. The Bank also pays Bank Rate on the reserves created by QE, a cost that ultimately falls on the Treasury. Debt interest payments rise.
debt interest
debt interest
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Assumes: A large share of the debt is refinanced soon.
Assumes: A large share of the debt is refinanced soon.
But: UK gilts have one of the longest average maturities among advanced economies, so most existing debt keeps its old interest rate and costs rise only gradually.
3
At the same time, the rate rise slows growth, so receipts from income tax, VAT and corporation tax grow more slowly.
tax revenue
tax revenue
Assumes: The rate rise slows growth noticeably.
But: If the rise is small and the economy strong, the effect on tax receipts is small.
4
Consequently, spending on unemployment-related benefits rises as more people lose their jobs.
automatic stabilisers
automatic stabilisers
Assumes: Unemployment rises.
But: If firms hoard labour, unemployment and benefit spending rise very little.
End
The budget deficit widens, and debt interest takes up a larger share of public spending.
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Questions this answers
- Explain how higher interest rates might affect the government's budget position.
- Assess the impact of rising interest rates on UK public finances.
- Discuss the possible conflicts between monetary and fiscal policy.
Diagram
No standard diagram. A sketch of debt interest as a share of GDP over time works well as evidence.
Reverse and related
Bank Rate cut → cheaper borrowing → deficit narrows.