ChainWhat it assumes · how to break it
Start
The Monetary Policy Committee raises Bank Rate, for example from 4% to 5%.
1
As a result, the cost of borrowing rises for households and firms as banks raise their own rates.
transmission mechanism
transmission mechanism
Assumes: Banks pass the rise on.
But: With most mortgages on fixed deals, the effect is spread over several years rather than felt at once.
2
This means households cut spending, especially on goods usually bought on credit such as cars and furniture. Consumption falls.
consumer durables
consumer durables
Assumes: Household incomes are not rising fast.
But: If real wages are growing strongly, spending may hold up despite dearer credit.
3
At the same time, firms postpone or cancel investment projects that no longer cover the higher cost of borrowing.
investment
investment
Assumes: Investment responds to interest rates.
But: Confidence and expected sales usually matter more to investment than the interest rate.
4
In addition, higher UK rates attract hot money, so the pound appreciates; exports become dearer abroad and imports cheaper, so net exports fall.
hot money · exchange rate
hot money · exchange rate
Assumes: UK rates rise relative to rates abroad.
But: If other central banks raise rates too, the pound may not rise much.
5
Therefore, AD shifts left, and through the multiplier the first fall in spending leads to a larger fall in national income.
multiplier
multiplier
Best link to attack
Assumes: The multiplier is large.
Assumes: The multiplier is large.
But: The UK is an open economy with high leakages into imports and tax, so its multiplier is fairly small and the fall in income is limited.
End
Real GDP growth slows, and may turn negative if the rise is large.
Time lag: output usually responds sooner than inflation, which is why rate rises often hit growth before they bring inflation down.
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Questions this answers
- Assess the likely impact of an increase in interest rates on economic growth.
- Discuss the trade-off between inflation and growth when interest rates rise.
- Examine two reasons why a rise in Bank Rate might reduce real GDP.
Diagram
AD/AS: AD shifts left; real output falls from Y1 to Y2.
Reverse and related
Bank Rate cut → growth rises.