Economics

Economics

The Interest Rate (IR) is considered as one of the most important economic factors affecting every household, firm and government all over the world. It is, as described by Parkin et al (2005), the opportunity cost of holding money, that is, the price of borrower are willing to pay for the use of the loan. On the other hand, it is also the compensation to the risk that lenders take in lending the money. (investopedia.com, n.a. 2003) By lenders and borrowers, it refers to individuals, businesses, financial instruments and governments. IR can be also categorised into nominal IR that is the stated one on financial market and real IR that implies the return of investment in terms of value. IR is said to be an indicator of economy situation and reflection of government policy as well. Therefore fluctuations of IR would have great impact on different areas in the economy and it is crucial to understand what determines it and how it would affect the world.

This paper presents a general analysis of models of determinations s of interest rate, which are relevant to the UK economy. Thereafter, the effects of changes in IR to the economy growth will be examined. Then a conclusion will be drawn to generate the key points the paper has mentioned.

Out of all, state of economy is the fundamental parameters of IR. (Toews, 2006) when an economy experiences a growth period, IR is decreased to stimulate the amount of money circulating in the market. Conversely, IR is relatively high when a stagnation or recession occurs.

Figure 1 illustrates the relationship between real GDP which represents the economic grow and IR over 40 years in the UK. In the late 1980s the UK experiencing a huge stagnation period and from the figure the IR was high and the gap between IR and real GDP. During the late 1990s the UK economy were growing and the IR dropped. The observations reveal that a high growth will lead to low interest rate and vise versa.

Same as other commodities, there is a market for money. The money supply is the relation between quantities supplied and IR, when other influences remain the same. (Parkin et al, 2005. pp 594) Originally it is provided by central bank, in the case of the UK, Bank of England. Then other financial intermediaries like commercial banks loan money from the central bank and invest to public. In the UK, change in supply results from the change in the amount of money available to borrowers and will influence interest rate. (Heakal, 2003)

As figure 2 shows, a rise in quantity supplied shifts supply curve MS0 to MS1. In effect IR is decreased and it could be interpreted that as more funds are available now so opportunity cost of holding money is reduced. A fall in quantity supplied would cause the opposite effects.

The demand for money would also have impact on IR. (Parkin et al, 2005. pp 597) An increase in demand shifts demand curve MD0 rightwards to MD1 in figure 3, as a result IR rises. This is because as the demand is