Monetary policy is the manipulation of financial tools such as interest rates by a
central bank to achieve macroeconomic objectives.
The case study states that “Lower interests reduce the cost of borrowing for
households and firms.” this incentivises consumers to spend on more on high-
cost goods such as cars, and an increased consumption of other lower-cost goods
and services such as snacks. Firms notice this rise in AD and begin to expand
output. In order to do this, firms must also increase investment. An increase in
investment leads to more jobs being created, so unemployment begins to fall.
Additionally, as Investment is also a component of AD, it rises further. This
increase in AD leads to an increase in the real GDP, achieving economic growth.
However, low interest rates may not always beneficial. In a recession or a slump,
central banks may decrease the interest rates to stimulate economic activity.
Despite this, consumers and businesses alike may be reluctant to borrow due to
a sharp decline of confidence in the economy. This was seen in the UK in the
2008 financial crisis where interest rates dropped as low as 0.25%, yet people
were still not borrowing. Additionally, reducing interest rates in an attempt to
increase investment to create jobs will fail to rectify structural unemployment. If
workers lack the skills to take up jobs, vacancies will remain open and investing
will not lead to a large increase in real GDP. In fact, if real GDP does not increase
but the price level increases due to higher AD, then inflation will increase.
Interfering with the objective of maintaining price stability. This is seen in
Diagram 1.
Lower interest rates reduce saving as the returns on saving fall. This makes the
pound weaker, as foreign investors begin to pull their savings and capital from
the UK and move their funds elsewhere, where they can get higher returns. This
decreases the demand for the pound, and it depreciates. This is evident in the
case study where it states that “lower interest rates […] weaken the exchange
rate.” A weaker pound makes UK exports cheaper for foreign countries and
makes imports more expensive for UK residents. Demand for our exports
increases and demand for imports decreases, improving our net exports, and the
current account of the balance of payments.
However, a weaker exchange rate will fail to benefit the balance of payments if
the world economy is not in a good state. If the UK’s trade partners are currently
in a recession, their they will not buy more UK goods regardless of their price,
even possibly resulting in a decrease in exports. Additionally, weaker exchange
rates can cause cost-push inflation. Imported raw materials and food become
more expensive, raising costs. This shifts SRAS to the left, causing inflation. This
also interferes with the objective of maintaining price stability. In turn, the bank
of England may be forced to raise interest rates to counter inflation, undoing the
original policy.
In conclusion, lower interest rates are important, albeit insufficient to achieve
macroeconomic objectives. In a stable economy, they prove to be excellent to
increase growth, reduce unemployment, and improve the balance of payments.
However, when in a recession or slump, their effectiveness is greatly diminished,
where consumers are unwilling to borrow even at rates near 0%. Furthermore,
persistent low rates can cause a sharp decline in foreign investment in the long
run. Therefore, while interest rates are an excellent short-run tool to achieve
macroeconomic objectives, their importance should not be overestimated, and
they should be paired with other tools such as fiscal policy.