The Impact Of The Exchange Rate And Money Supply On Growth

Low-Interest Rates: Effects

Describe about The Impact Of The Exchange Rate And Money Supply On Growth?

The British economy has faced a very low-interest rate from past 6-7 years. Hence, the borrowings have been attracted and investment level becomes encouraged. It has also raised the spending of British citizens. Increasing spending leads to a higher aggregate demand of the citizens of UK and hence higher levels of growth can be achieved. However, with lower interest rate, inflationary pressure (demand pull inflation) has occurred in the British economy.  Inflation will have hampered the buying power and the economic expansion sustainability can be undermined (Kirby, 2013). The Central Bank of England should undertake various reforms and policies to control the situation by enhancing the interest rate.

This report will try to show the various effects of low-interest rates by incorporating macroeconomic as well as microeconomics concepts in the context of the British economy and it will also discuss the reforms which will be undertaken by the Central Bank of England.

The possible impacts of low-interest rates can be discussed.

Firstly, when the interest rate is low, it makes the borrowing costs very cheap. Cheaper costs attract the loan – taking the behavior of UK citizens and also the business firms to finance the ventures and also for higher spending.

Secondly, from savings, the lower return was generated due to the lower interest rates. Hence, people of Britain have a lower incentive to save their money. It will imply that spending of customers is attracted rather than holding.

Thirdly, due to the lower rate of interest, buying assets like housing is encouraged. Thus, prices of the house have been raised which causes a rise in the wealth. Thus, customer spending increases.

Fourthly, lower savings will decrease the value of currency (Perloff, 2012). The downfall in the exchange rate will imply of costlier import. Thus, AD has been affected.

Lastly, the monthly costs of mortgages are lowered due to low-interest rate. It will raise the disposable income and hence customer spending.

In general, aggregate demand model can be very useful to show the effects of lower interest rate.

AD = C+I+G+ (X-M).

With the lower rate of interests, the components of AD such as C, (X-M), I will increase. Generally, when the interest rate is lower, the growth of the economy will increase as AD will increase. Figure 1 will help to see the relationship between AD and interest rate.

Macroeconomic Model – Aggregate Demand

Figure 1: AD and Interest rate

Source: (Krugman and Wells, 2013).

The lower interest rate shifts the AD curve to the right (AD^/). AS curve will no change in this case (figure 2).

Figure 2: AD –AS model

Source: (Mankiw, 2013).

It can be seen from the figure 2 that Real GDP has been increased due to the lower rate of interest (Y₂) as AD is raised. Thus, by using the AD –AS model, it can be shown that although inflationary pressure will arise also with higher AD, the lower interest rate will generate higher economic growth in Britain.

It can be seen from the below table that the interest rate of past 7 years was low and this situation encourages in achieving the level of economic growth in the UK.

Table 1: Interest rate data (Data.worldbank, 2016)

Based on the table, the column graph can be made.

Figure 3: Fluctuations in Interest rate

Source: (Author)

It can be seen that from 2010 to 2014, the interest rate is constant that is 0.5%. The lower interest rate can have different effects on the different groups of people in the UK. Due to a lower rate of interest, the borrowers, mortgage holders and the owners of the houses get the maximum benefits in the UK. These group of people will devote extra money. However, people who generally saves money, face the adverse impacts of lower interest rate (Sirichand and Hall, 2015). The retired citizens come into this group who have less disposable income because the return from savings has been lowered. Thus, they will spend less money. UK economy is known as borrowers’ region. A higher level of debt mortgage can be seen here. Hence, it can be said that lower interest rate will have a huge impact on UK economy. In this scenario, EU has a higher tendency to take rental home rather than purchasing (Field, 2014). Current account section had affected by the lower interest rate. In this scenario, exports become competitive and import becomes costlier. It causes a depreciation in UK economy. On the other hand, the lower interest rate will increase the import demand (Gordon, 2012). Thus, in UK economy, people have elastic demand. So, effects will confuse the researcher.

Apart from this, the adverse impact can be seen in the service sector. The lower interest rate has created too much turmoil in the financial segments and thus, the growth rate has been affected adversely from the past years.

Lower Interest Rate in UK economy: Impacts

Figure 4: Growth rate in the UK

Source: (Data.worldbank. 2016).

In Figure 4, it ca be seen that growth rate is positive from 2010 but these are very low up to 2012. In 2009, the debt crisis had made the GDP growth rate negative and the interest rate was also low (Tradingeconomics. 2016).

The picture of the service sector has implied that various venture actions in Britain cover the hairdressers of insurers as well as had expanded with a low rate of march 2013. During this time, the economy of UK was said to be a fragile economy where recessive situations had arisen.

To control this scenario, the Central Bank of England should try to do modifications in the monetary policy to gain the monetary stability and control inflationary pressures. It also tries to manage the economic consequences and the social dilemmas. To control the rate of interest, the authority should focus on some factors. Otherwise, there will be high chance of arising information failure. To control the interest rate by modifying the monetary policies, the policymakers should have pure knowledge about the economy of UK. The growth rate of GDP and the size of output gap must be considered. Without knowing these, the bank cannot manage the level of AD in the UK. Bank lending and the customer credit should be considered. It involves the equity withdrawal from the market of homes along with lending data of credit cards from which the consumer demand can be analyzed.

To manage this odd situation, the CBE can undertake the contractionary monetary policy. The contractionary policy can reduce the demand of citizens and thus AD curve will move leftward (AD^//). The rate of interest will go high. This policy is used to lower the money supply along with spending of customers. When interest rate will move up for perceiving the contractionary policy, it will enhance the reserve requirements as the supply of money will be lowered (Bhattarai, 2011). After allocating a higher rate of interest, the banks and government will borrow at the higher rate. This will raise the lending costs. Other banks must follow the rule of Central bank which will reduce the borrowing of the citizens. By doing this, inflation rate can be controlled too by the CBE. It can be also said that with the increase in interest rate, savers of UK become satisfied again. When saving will be higher, the retired citizens can increase their spending. The Central Bank can enhance the reserve requirements over the other commercial banks to scrutinize the withdrawals regularly. The banks borrow at a lesser rate from the customers of UK when there is a greater requirement of reserves. Therefore, the spending of the UK citizens will be started declining inevitably. Thus, the demand-pull inflation can be managed.

The Central Bank of England can directly or indirectly do the reduction in money supply. When there arises greater demand, the contractionary monetary policy can increase the value of exchange rate (Hubbard and O’Brien, 2012). It can stimulate the import at a higher rate and also lower the export. In this way, the authority can manage the money circulation across the UK economy.

Conclusion

In this section, it can be shown by the researcher that the interest rate of UK had a tendency to fall for the past 6-7 years. In this report, the effects of lower interest rate are discussed with the help of Aggregate demand model and the concepts of microeconomics. With a lower rate of interest, aggregate demand rises and growth rate increases. However, it has created inflationary pressures in UK economy and adversely affected the savers. Therefore, the Central Bank of England must undertake a contractionary monetary policy to manage the inflationary situation and manage the value of exchange rate. Spending can be reduced by perceiving the policies and money circulation can be managed by the authority.

References

Bhattarai, K. (2011). The impact of the exchange rate and money supply on growth, inflation and interest rates in the UK. IJMEF, 4(4), p.355.

Data.worldbank. (2016). GDP growth (annual %) | Data | Table. [online] Available at: https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?page=1 [Accessed 21 Mar. 2016].

Data.worldbank. (2016). Lending interest rate (%) | Data | Table. [online] Available at: https://data.worldbank.org/indicator/FR.INR.LEND

Field, M. (2014). Reappraising the place for private rental housing in the UK market: Why an unbalanced economy is at risk of becoming even worse… Local Economy, 29(4-5), pp.354-362.

Gordon, R. (2012). Macroeconomics. Boston: Addison-Wesley.

Hubbard, R. and O’Brien, A. (2012). Microeconomics. Harlow: Pearson Education.

Kirby, S. (2013). Prospects for the UK Economy. National Institute Economic Review, 226(1), pp.F46-F64.

Krugman, P. and Wells, R. (2013). Macroeconomics. New York, NY: Worth Publishers.

Mankiw, N. (2013). Macroeconomics. New York, NY: Worth.

Perloff, J. (2012). Microeconomics. Boston: Pearson Addison Wesley.

Sirichand, K. and Hall, S. (2015). Decision-Based Forecast Evaluation of UK Interest Rate Predictability. Journal of Forecasting, 35(2), pp.93-112.

Tradingeconomics. (2016). United Kingdom Interest Rate | 1971-2016 | Data | Chart | Calendar. [online] Available at: https://www.tradingeconomics.com/united-kingdom/interest-rate.