INTEREST RATES: DOES HAVING A LOWER INTEREST RATE STIMULATE ECONOMIC GROWTH?

DOES HAVING A LOWER INTEREST RATE STIMULATE ECONOMIC GROWTH?

You may have seen in the news recently and seen headlines such as ‘A RECORD LOW UK INTEREST RATE!’ or ‘Bank of England still firmly against interest rate rise’. This is relevant and important because many people want to see the rate of interest start to increase again, and soon. People want this because it will enable us to improve the value of the pound and so attract more hot money flows i.e. foreign economic agents placing money in our banks which will enable us to improve our current account deficit.

As I’m sure many of you know, the interest rate is the cost of borrowing, the reward for saving and the actual cost price of money. Economic growth is an increase in an economy’s productive potential, an increase in real GDP.

It should be noted that in macroeconomic terms, performance of an economy does focus a lot on economic growth but it also covers other economic performance indicators such as unemployment, debt levels, competitiveness, purchasing power, and human development among many others.

Having a lower rate of interest may increase levels of consumption as the relative potential gains from saving money would be reduced, or discouraged if you will, and so economic agents are more likely to spend their money. These higher levels of discretionary income would lead to higher levels of aggregate demand (the demand for the GDP of a country).

A lower interest rate may also increase levels of investment both home and abroad. This would happen because borrowing would be relatively cheaper and also firms will expect higher sales due to the aforementioned increase in consumption levels.  This therefore means that the opportunity cost of investment will fall and so makes it more likely that investment will occur.

This lower rate would also improve the current account position. This is because a lower interest rate would, in theory, reduce the exchange rate.  This makes imports relatively more expensive but at the same time makes exporters better off as their products will be comparatively cheaper than before compared to other exporters in the global market.

It may also lead to higher levels of supply (aggregate supply) due to higher levels of investment which inevitably leads to an increase in the productive capacity of an economy.  

So overall, lowering the rate of interest could increase levels of both supply and demand and so output (GDP). This therefore means economic growth…. Or does it?

In evaluating this idea that lowering interest rates would stimulate economic growth, one needs to account for several things.

For example, the effect of lowering the interest rates depends on the size of its reduction. Proportionally, the aforementioned effects would be larger and more significant if the size of the change was larger. If the interest rate was reduced from say 1% to 0.5% then it would be of less significance to economic growth than if say it was reduced from 5% to 0.5%.

Moreover, its effect will be influenced by the initial level of economic activity. It is more beneficial for an economy if before the rate reduction it was operating with spare capacity. If it wasn’t, then the rate reduction would cause only an increase in price levels due to higher demand levels i.e. demand-pull inflation.

Furthermore, lowering the rate of interest may not lead to higher levels of aggregate demand if the economic agents (firms and consumers) lack confidence – typical of recession time economies.

It should be noted that with sustained and sustainable economic growth in the long run, it is important that both demand and supply levels increase otherwise this can lead to imbalances in growth and development.

If you fancy learning more about economics and the financial world around you check out my other articles on my blog: http://insighteconomics.blogspot.co.uk/

Thanks for reading and if you have any queries please email me at:samandchrisshapley56@gmail.com or post a comment on the page itself and I’ll try to get back to you as soon as I can.