An increase in interest rate is one of the approaches used by governments to control the level of inflation. Countries like Britain have a target inflation rate of 2%, but currently the rate stands at 4%. This explains why the British pound is the strongest currency.
Raising and lowering interest rates influences many sectors of the economy. This is because the Bank of England is the central bank, and thus distributes money to other financial institutions.
As illustrated in the flow chart, the rate offered by the Bank of England influences the rates in other fields such as borrowing and money markets. It is just like in an ordinary market place where the retailer sets the price according to the prices offered by the wholesaler.
For instance, if a fisherman increases the prices of his fish, then the fish monger will also increase the price at which he sells to the consumers and vice versa.
Effects of Increasing Interest Rate
When the Bank of England increases its lending rates the financial institutions must reflect this increment by adjusting the rates at which they issue loans.
Pettinger points out that this action causes people to hesitate from applying for loans because they know they will pay a lot of money accumulated as a result of high interest rate (1).
However, the money that is kept in the banks accumulates commendable interest and hence people choose to withhold the money they have kept in the banks. In such a case, the financial institutions would have to increase the repayment period.
Alternatively, having low interest rates induces people to take loans because they are certain that they will repay in due time. The increase in rates also affects companies in the housing sector because the increase in rates leads to a decline in the number of people who apply for mortgages: the opposite causes more people to apply for mortgages.
This is because people consider the rate of accumulated interests and the repayment period. Mortgage companies adjust their rates because the swell in interest rates causes the price of building materials to increase, and thus if they ignore the changes in the market there will be no profits.
The people who had taken loans prior to increment of interest rates feel the pinch because they will pay more money than they expected. In such a case, it is the creditors that benefit because they will get more returns.
An increase in interest rates is also an influential factor in foreign exchange because it causes the value of the local currency to increase against those of foreign nations.
Mueller argues that this attracts foreign investors because they know the returns they will earn from doing business in UK will be much more when they convert the money into their respective currencies. An increase in foreign investment causes more money to be circulated in the economy. Besides that, it causes the costs of international products to decline.
Additionally, increased foreign investment causes people to minimize their expenses due to the sudden increase in the price of products and services. This swelling is caused by an increase in importation duties, and thus when the products are brought to the market their costs are inclusive of the levies that were charged on them.
This is necessary because if the merchants do not extend these charges to the consumers they probably would not make any returns. However, this increase on import duties is advantageous to local industries because they discourage people from importing goods that are available locally.
The stock market is also affected by the increase in interest rates because it causes the cost of shares to go up. This means that a few pounds can buy many items, and thus people will spend more. Similarly, an increase on interest rates encourages people to import more products because they spend less money because the value of sterling pound is much higher than other currencies.
High interest rates cause the national debt to swell, and thus the government of Britain would have to increase the rates of taxation. This is because when the national debt swells more money is used to offset the national loan, and hence the government has to look for alternatives of generating revenue so that it does not cut back on its expenditure.
Furthermore, the increment of interests causes unemployment to reduce and the employees get a better pay. This rise in the number of employed persons generates a lot of revenue for the government because those people will be taxed.
The payments issued to pensioners would have to be increased, but this is done after evaluating the rate of inflation. The employees who earn constant salaries suffer the most because the money that is used to sustain them becomes useless, and thus they have to negotiate for a salary increase, which can cost them their jobs.
Sometimes, it is not the central government that causes the interest rate to hike. This implies that there are other forces behind the rise in interest rates. For instance, when the people are in great need of loans – this raises the demand and hence the interest rates go up because the number of people who need the funds outnumbers the available funds.
Consequences of Not Increasing the Rates
The Bank of England keeps an eye on the economy, and raising the interests is used to prevent inflation, which can lead to civil unrest. This happens in cases where the public is certain that the inflation has been engineered by cartels.
This is because when employers find out that they are making losses they sack their employees, causing the level of unemployment to increase. When interest rates are low it can cause inflation and people may purchase the commodities that are mostly affected in bulk, and thus result in shortage of those products. This can result in a bigger crisis especially if the commodities are basic items like food stuffs.
The changes in interest rates puzzle potential investors because they are not sure whether they will gain from the seeds that they will sow at that time. This forces them to pull back their resources until they are guaranteed about the safety of their investment.
The people who benefit from increment of interest rates are the people who are focused on short term investments. This is because they will benefit from the high returns that would be obtained from their businesses.
For instance, in stock market the prices of shares may increase, but it is only for a short period. This suggests that if the prices drop it will take many years for the same increment to be realized.
Smart Options
When interests go up people do not have to lead cheap lives, but should instead be smart. This means that one should weigh the options that are available and settle on the most flexible option.
For instance, if keeping money in the bank generates an interest that is less than the rate of inflation, it would be wise to withdraw the funds and put it into other constructive use. It is advisable to get a mortgage on a fixed rate because that way one will be cautioned from the future changes in the market.
When purchasing items, people should give the first priority to the items that are needed most. Investments should be made on durable items such as land and houses because their value can hardly decrease.
Works Cited
Bank of England. How Monetary Policy Works. Web.
Mueller, Jim. How Interest Rates Affect the Stock Market. 2006. Web.
Pettinger, T. Interest Rates Explained. 2007. Web.