The UK economy is facing a significant downturn. After the V.A.T. reduction failed the expected increase in consumer spending, the UK uses intermediaries of the Monetary Policy (MP) to stimulate the economy. On the March, 5th 2009, the Bank of England announced that they lower the bank rate paid to commercial banks from 1% to 0,5% to ensure that the inflation target of 2 % will be achieved. (www.bankofengland.co.uk) On the base of the economic theory it will be discussed what the influences of a cut in interest rates are on the UK economy, the effects on the current financial situation and on easyJet plc.
Explain using economic theory what the effects of a cut in interest rates will be on the UK economy as a whole.
The Bank of England’s Monetary Policy Committee (MPC) is responsible for the stability in the financial system. One of their functions is to change the interest rate to adjust the inflation to forecasted developments in the Consumer Price Index (CPI). (Sloman 2007 p. 284) A cut in the rate of interest affects the macro-economy because it increases the money supply and simulates the aggregate demand (AD). This is known as transmission mechanism (Sloman 2007 p. 296) and affects the economic cycle in different ways.
BoE lends money to financial institutions, such as commercial banks and building societies. If the banks borrow money for a lower interest rate, they match their interest rates for their customers.
Firstly, a reduced interest rate makes saving less interesting for consumers. This is because savings accounts don’t achieve high profits anymore. Instead consumers tend to lend and spend more money. (www.bankofengland.co.uk) And a higher consumption of domestically produced goods and services leads to a higher output of production. (Sloman, 2007 p. 238) If companies produce more the demand for labour rises what brings down unemployment. This is called accommodation. (Anderton 2006 p.602)
Secondly, the interest rate is an important determinant of investment. A fall in the market rate makes investments more profitable for companies because the expected return on investment rises. (Hardwick et al. 1999 p. 422)
Thirdly, higher spending increases the velocity of money and the cash flow of companies. This makes companies more confident that sales figures will rise and they increase their production and are encouraged to invest more. (Sloman 2007 p. 301)
Fourthly, it also increases the price of assets, such as shares, bonds and house prices. But the interest payments due on loans and mortgage rates decreases. (www.bankofengland.co.uk)
Additionally, a reduction of the interest rate influences the exchange rate. If the interest rate is lowered the exchange rate for Sterling falls, because of decreasing demand. (Anderton 2006 p. 569) This makes the UK more competitive in the global market. When the Sterling is worth less, foreign countries tend to import more goods from the UK. A higher net-external demand increases the production of UK companies. However, the import of goods slows down, because foreign currencies become more expensive what makes import less attractive. (Sloman 2007, p. 297)
Overall, those factors are stimulating the AD and bring the national output in the UK closer to its productive potential. (Sloman 2007 p. 267) Because, a rise in consumer and government consumption, an increase in the level of investment and export, followed by a slowdown in import, leads to a macroeconomic equilibrium. That means a rise in the GDP and a growth in national wealth. (Sloman 2007 p. 267)
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The UK economy is currently experiencing a downward trend caused by broken sub-prime mortgage deals in the US. House prices have fallen dramatically. Consumer confidence changed negatively what lowered the demand for goods in the last year. This led the UK into recession and will cause the CPI to fall under the 2% target in the medium term. (The Sunday Times, Smith)
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- Interest rates UK economy Easy Jet plc. recession Credit crisis Monetary Policy Fiscal Policy Bank of England