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1 Introductory concepts 2  Market mechanism  3 Elasticities  4 Market structures 5  Market failures  6  Macro economic activity/eco growth  7 Inflation 8  Employment & unemployment  9  External Stability  10  Income distribution 11.Factors affecting economy  12  Fiscal/Budgetary policy  13  Monetary Policy   14 Aggregate Supply Policies  15 The Policy Mix

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Interest rates

 

When interest rates increase, it is likely to have both demand and supply side effects.  The household and business sectors are likely to reduce demand for goods and services because the cost of borrowing is higher.  Households are less likely to use credit cards and less likely to take out loans for the purchase of consumer durables (e.g. boat, ipod, plasma TV, etc).  Similarly, businesses are less likely to invest (e.g. to purchase new machinery or build an additional plant) as the higher cost of borrowing makes it less attractive to borrow.  In addition, the higher costs to finance existing loans for households and businesses (e.g. mortgages for the average household) causes them to experience a drop in 'cash flow' (i.e. a fall in discretionary income), which further reduces both Consumption and Investment.  


As both Consumption and Investment decreases, AD necessarily falls and there is a corresponding negative impact on real GDP and economic growth in the medium to longer term (that is, taking into the lagged effect which could be up to 18 months).  The higher borrowing costs for businesses exerts upward pressure on prices and inflation, but this is outweighed by the reduced demand inflationary pressure coming from the effects on C and I, and low inflation is more likely to be achieved.  

 


The lower rates for real GDP are likely to cause the demand for labour to fall, employment growth to drop and unemployment to rise - making it more difficult to achieve full employment.  with higher unemployment, it is expected that equity in the distribution of income becomes more difficult to achieve as there is likely to be a greater reliance on welfare. It is also reasonable to argue that higher interest rates have a relatively harsher effect on lower income earners as they are more likely to be net borrowers compared with higher income earners who are more likely to be net lenders.


 

The higher interest rates can have conflicting influences on the achievement of external stability.  On the one hand, higher rates can reduce AD or spending (GNE) and reduce the gap between national spending (GNE) and income (GDP), thereby improving the CAD.  On the other hand, the higher interest rates attract capital inflow (in the form of overseas lenders chasing higher returns) and exert upward pressure on the value of the $A.  This worsens Australia's international competitiveness, reducing net exports (X-M) and increasing the CAD and NFLs.  [This conflict is the reason why the RBA will not increase interest rates to reduce the CAD - see monetary policy].


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