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, banks raise the rates they charge on mortgages and loans and the rates they pay on savings.
transmission mechanism
transmission mechanism
Assumes: Banks pass the rise on to both borrowers and savers.
But: Banks often raise loan rates faster than savings rates, so savers may gain less than borrowers lose.
2
This means borrowers, typically younger households with large mortgages and lower-income households using credit, pay more interest, so their disposable income falls.
disposable income
disposable income
Best link to attack
Assumes: The people who borrow are poorer than the people who save.
Assumes: The people who borrow are poorer than the people who save.
But: Many of the poorest households rent and have no mortgage, so the direct hit falls on middle-income homeowners; though landlords may pass higher costs into rents.
3
At the same time, savers, who are disproportionately older and wealthier, receive more interest income.
income from wealth
income from wealth
Assumes: Savings are concentrated among the better-off.
But: If inflation is above the savings rate, real returns are still negative, so savers gain less than it looks.
4
Consequently, income is redistributed from borrowers to savers, widening gaps in disposable income between age groups and between households with and without savings.
redistribution
redistribution
Assumes: The two effects do not cancel out.
But: Many households are both borrowers and savers, so the net effect on each is smaller than the gross flows suggest.
5
In addition, if the rate rise slows the economy, job losses fall hardest on low-paid and less-skilled workers.
cyclical unemployment
cyclical unemployment
Assumes: The lowest paid lose their jobs first.
But: Unemployment benefits act as an automatic stabiliser and cushion the fall in income.
End
Income inequality is likely to widen, and the Gini coefficient rises.
Attack the whole chain: Higher rates tend to push down house and share prices, which cuts the wealth of asset owners. Wealth inequality may therefore narrow even as income inequality widens.
Can you say this chain from memory?
Members can hide the links, test themselves and track which chains they have mastered.
Practise this chainMembers can hide the links, test themselves and track which chains they have mastered.
Questions this answers
- Assess the impact of higher interest rates on the distribution of income.
- Discuss whether a rise in interest rates affects all households equally.
- Evaluate the costs of using monetary policy to reduce inflation.
Diagram
Lorenz curve: the curve moves further from the line of equality and the Gini coefficient rises.
Reverse and related
Bank Rate cut → borrowers gain, savers lose, and asset prices rise.