TOPIC: IMPACT OF INTEREST RATE ON CONSUMER SPENDING.

Group Members:

Mehak Akhlaq
Anzal Nadeem
Anika Muneer.

Anas Sami.

Course Name:Macro Economics

Submission Date:20th-April-2019
Faculty Name: Ms. Ameena
 Anas Sami.
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Interest Rate

Interest rates are the cost of borrowing money. Interest rates are normally expressed as a % of the total
borrowed, e.g. for a 30-year mortgage, a bank may charge 5% interest per year.

Interest rates also show the return received on saving money in the bank or from an asset like a
government bond.

Different types of interest rates

Central Bank Base Rate

 The base rate is the interest rate which the Central Bank lends money to the commercial banks.
 This base rate is the most important interest rate because it tends to influence all the other interest rates
in the economy.
 If the Central Bank increases the base rate. Commercial banks find it more expensive to borrow from the
Central Bank. Therefore, they pass this onto their consumers.
 Indirectly, the Central Bank rate affects all interest rates in the economy – from mortgage rates to the
saving rate you get in a savings account
 How the Central Bank set the interest rate

Commercial Bank Rate

Commercial banks are free to set their own interest rates, but it tends to be strongly influenced by the
Central Bank base rate. If they find it more expensive to borrow from the Central Bank, they tend to
increase their commercial rates.

This shows that banks tend to follow the Central Bank base rate, but from 2009, there was a bigger gap
between bank SVR and Base rate. Commercial banks didn’t pass the full base rate cut onto their
customers.

Standard Variable Rate (SVR). This is the most common lending rate for the bank. Sometimes, banks
may give discounts to consumers from their SVR, but the SVR will be the main lending rate for a bank.

Mortgage Interest Rates

Mortgages are a type of loan secured against the value of a house. Banks are willing to lend large sums
at relatively low interest because if the mortgage holder defaults, the bank can legally reclaim the house
and secure the value of its loan.
 Fixed Mortgage Rates. Banks may offer a fixed mortgage rate (e.g. 2 years, 5 years, 10 years) this gives
mortgage holders greater security over the cost of monthly mortgage payments.
 Tracker Mortgage Rates. Banks may offer a mortgage where the mortgage rate follows the Central Bank
base rate. If the Central Bank reduce base rates to 0.5%, the mortgage rate will fall to a similar level.
 Variable Mortgage Rate. A mortgage rate which is determined by the banks SVR.

Saving Rates

 Interest Rate on Current account (perhaps – 0.5%) . Many banks may pay savers very little interest for
their savings in a current account. This is because savers can have instant access to their savings so the
bank needs to keep more cash in reserve and these cash deposits are not very profitable for the bank.
 Interest rate on savings account (perhaps 2-4%.) For saving accounts, banks can pay a higher rate of
interest. This is because money is less likely to be withdrawn. The bank may even place limits on access
to funds (e.g. you have to give 7-day notice) This means the money can be more profitable for banks as
they use it to lend to other people.

Loanable Funds Theory

The loanable funds theory states that interest rates will be determined by the supply and demand for
funds. If people save more, there will be more funds for investment, this will reduce interest rates. If
demand for borrowing increases, this will push up the cost of borrowing.
The equilibrium interest rate is at R1 – when demand equals supply for loanable funds. In the credit
crunch (2008-11), a shortage of funds pushed up bank rates.

Real Interest Rate

 The real interest rate shows the nominal interest rate – inflation. E.g. if interest rates are 5%, and the
inflation rate 3%, the real interest rate is 2%. It means savers will see an increase in the value of their
savings, despite inflation of 3%.

See also: Real Interest Rates

Negative Real Interest Rate

A negative real interest rate means that the nominal interest rate is less than the inflation rate. e.g. if
interest rates are 5%, but inflation is 6%, then there is a negative real interest rate of -1%. It means
savers see the value of their money fall by more than the interest payments they get. In 2011, inflation
was 5%, whilst base rates were 0.5%.

See: Negative Real interest rate

Bond Yields

 Bond yields show the interest payments that someone will get from buying a bond, such as UK
government bond.
 E.g. if the 10-year bond yield on a government bond is 3%, it means someone who holds a £1,000 bond
will be getting £30 interest a year.
 If people sell bonds on the open market, this pushes down the price of bonds, and increase the bond
yield. See Relationship between bond price and bond yields.
 Bond yield curves

Interest Rate Cycle

 interest rate cycle – how interest rates change with the economic cycle.
 ANZAL NADEEM.
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Effect of raising higher interest rates on

consumer spending.
The Central Bank usually increase interest rates when inflation is predicted to rise
above their inflation target. Higher interest rates tend to moderate economic
growth. They increase the cost of borrowing, reduce disposable income and
therefore limit the growth in consumer spending. Higher interest rates tend to
reduce the rate of economic growth and inflationary pressures.

1. Increases the cost of borrowing. With higher interest rates, interest payments on
credit cards and loans are more expensive. Therefore this discourages people from
borrowing and spending. People who already have loans will have less disposable
income because they spend more on interest payments. Therefore other areas of
consumption will fall.
2. Increase in mortgage interest payments. Related to the first point is the fact that
interest payments on variable mortgages will increase. This will have a significant
impact on consumer spending. This is because a 0. 5% increase in interest rates can
increase the cost of a £100,000 mortgage by £60 per month. This is a significant
impact on personal discretionary income.
3. Increased incentive to save rather than spend. Higher interest rates make it
more attractive to save in a deposit account because of the interest gained.
4. Higher interest rates increase the value of a currency (due to hot money flows.
Investors are more likely to save in British banks if UK rates are higher than other
countries) A stronger Pound makes UK exports less competitive – reducing exports
and increasing imports. This has the effect of reducing aggregate demand in the
economy.
5. Rising interest rates affect both consumers and firms. Therefore the economy is
likely to experience falls in consumption and investment.
6. Government debt interest payments increase. The UK currently pays over
£30bn a year on its national debt. Higher interest rates increase the cost of
government interest payments. This could lead to higher taxes in the future.
7. Reduced confidence. Interest rates affect consumer and business confidence. A
rise in interest rates discourages investment; it makes firms and consumers less
willing to take out risky investments and purchases.
 Effect of raising lower interest rates on consumer
spending.
 Lower interest rates make it cheaper to borrow. This tends to encourage spending
and investment. This leads to higher aggregate demand (AD) and economic
growth. This increase in AD may also cause inflationary pressures.

Reduce the incentive to save. Lower interest rates give a smaller return from
saving. This lower incentive to save will encourage consumers to spend rather than
hold onto money.
 Cheaper borrowing costs. Lower interest rates make the cost of borrowing
cheaper. It will encourage consumers and firms to take out loans to finance greater
spending and investment.
 Lower mortgage interest payments. A fall in interest rates will reduce the
monthly cost of mortgage repayments. This will leave householders with more
disposable income and should cause a rise in consumer spending.
 Rising asset prices. Lower interest rates make it more attractive to buy assets such
as housing. This will cause a rise in house prices and therefore rise in wealth.
Increased wealth will also encourage consumer spending as confidence will be
higher. (wealth effect)

Depreciation in the exchange rate. If the UK reduce interest rates, it makes it

relatively less attractive to save money in the UK (you would get a better rate of
return in another country). Therefore there will be less demand for the Pound
Sterling causing a fall in its value. A fall in the exchange rate makes UK exports
more competitive and imports more expensive. This also helps to increase
aggregate demand.
 Name:Mehak Akhlaq
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Consumer Spending
Consumer spending is another term for voluntary private household consumption,
or the exchange of money for goods and services in an economy. Contemporary
measures of consumer spending include all private purchases of durable goods,
nondurables and services. In a purely free market, the aggregate level of private
consumer spending in an economy is necessarily equal to the total market value of
economic output.

The most direct impact on consumers is often the change in spending habits that
are associated with increases or decreases in the interest rate. Investopedia notes
that the first question many consumers face when interest rates change is: do I
spend or save? Interest exists in the first place to allow borrowers to spend money
immediately, rather than waiting to save up money to make a purchase. With lower
interest rates, more people are willing to spend more money to make big purchases
on items such as cars or homes.

When consumers are paying less interest it gives them more money to spend
overall, and creates a ripple effect of increased spending across the broader
economy. Conversely, higher interest rates mean that consumers will not have as
much disposable income to work with and will likely cut back on spending. Higher
interest rates are often coupled with increased lending standards at banks, which
end up making fewer loans.

Many economists, especially those in the tradition of John Maynard Keynes,

believe consumer spending is the most important short-run determinant of
economic performance and is a primary component of aggregate demand. Other
economists, sometimes known as supply-siders, accept Say’s Law of Markets and
believe private savings and production is more important than aggregate
consumption.

Breaking down consumer spending:

Investors and businesses closely follow consumer spending statistics when making
forecasts. Every year in the United States, the Bureau of Labor Statistics (BLS)
conducts consumer expenditure surveys to help measure spending. Additionally,
the BEA estimates consumer spending for monthly, quarterly and annual periods.

If consumers spend too much of their income, however, future economic growth
could be compromised because of insufficient savings and investment. Modern
governments and central banks often examine consumer spending patterns when
considering current and future fiscal and monetary policies.

Consumer Spending as an Economic Variable:

Consumption of final goods (i.e., not capital goods or investment assets) is the
result of economic activity. This is because individuals ultimately use these goods
to satisfy their own needs and wants; economists refer to this satisfaction as
“utility.”
Consumer spending is the demand side of “supply and demand"; production is the
supply. When economists or policymakers refer to aggregate demand, they simply
mean the combined market value of all consumer spending within a given area,
over a given period of time and at a specific price level.
By its very nature, consumer spending only reveals the “use” economy, or finished
goods and services. This is distinguished from the “make” economy, referring to
the supply chain and intermediate stages of production necessary to make finished
goods and services.
Most official aggregate metrics, such as gross domestic product (GDP), are
dominated by consumer spending. Others, including the much newer gross
domestic expenditures (GDE) or “gross output” (GO) reported by the BEA, also
include the “make” economy and are less influenced by short-term consumer
spending.

Consumer Spending as an Investment Indicator:

Consumers are, naturally, very important to businesses. The more money

consumers spend at a given company, the better that company tends to perform.
For this reason, it is unsurprising that most investors and businesses pay a great
amount of attention to consumer spending figures and patterns.

In fact, the American Association of Individual Investors lists real GDP as the
single most important economic indicator to watch. If consumers provide
fewer revenuesfor a given business or within a given industry, companies must
adjust by reducing costs, wages, or innovating and introducing newer and better
products and services. Companies that do this most effectively earn higher profits
and, if publicly traded, tend to experience better stock market performance.

Effect of change in interest rate on consumer

spending habits :
Changes in interest rates can have different effects on consumer spending habits
depending on a number of factors, including current rate levels, expected future
rate changes, consumer confidence and the overall health of the economy.

It's possible for interest rate changes, either up or down, to have the effect of
increasing consumer spending or decreasing spending and increasing saving. The
ultimate determinant of the overall effect of interest rate changes primarily depends
on the consensus attitude of consumers as to whether they are better off spending
or saving in light of the change.

Keynesian economic theory refers to two conflicting economic forces that can be
influenced by interest rate changes: the marginal propensity to consume (MPC)and
the marginal propensity to save (MPS).These concepts basically refer to changes in
how much disposable income consumers tend to spend or save.

Spend or Save?

An increase in interest rates may lead consumers to increase savings, since they
can receive higher rates of return. An decrease in interest rates is often
accompanied by a corresponding increase in inflation, so consumers may be
influenced to spend less if they believe the purchasing power of their dollars will
be eroded by inflation.

The current level of rates and expectations regarding future rate trends are factors
in deciding which way consumers lean. If, for example, rates fall from 6% to
5% and further rate declines are expected, consumers may hold off on financing
major purchases until lower rates are available. If rates are already at very low
levels, however, consumers will usually be influenced to spend more to take
advantage of good financing terms.

The overall health of the economy impacts consumer reaction to interest rate
changes. Even with rates at attractively low levels, consumers may not be able to
take advantage of financing in a depressed economy. Consumer confidence about
the economy and future income prospects also affect how much consumers are
willing to extend themselves in spending and in financing obligations.
Anika muneer
#39971

THE EFFECT OF INTEREST RATE ON CONSUMER

SPENDING
Effect of raising interest rates

The Central Bank usually increases interest rates when inflation is predicted to rise
above their inflation target. Higher interest rates tend to moderate economic
growth. They increase the cost of borrowing, reduce disposable income and
therefore limit the growth in consumer spending. Higher interest rates tend to
reduce the rate of economic growth and inflationary pressures.

INFLATION AND RECESSION:

When the Fed intervenes to set interest rates, it is usually done to avoid either
inflation or a recession. Too little money in the market can mean a recession is
likely to occur as spending is severely curtailed by businesses and consumers. Too
much money and the value of money fall through inflation.

When interest rates are rising and falling, the Fed will adjust the federal funds rate
which is used by banks to lend money to one another. Movement of federal funds
rates affects all other loans as a result, and as such is used as an indicator of rising
and falling interest rates. If inflation indicators such as the consumer price index
and producer price index raise more than 2-3% in a given year, federal funds rates
are usually raised to keep rising prices under control.

AGGREGATE DEMAND

This will lead to a fall in Aggregate Demand (AD).

If we get lower AD, then it will tend to cause:
 Lower economic growth (even negative growth – recession)

 Higher unemployment. If output falls, firms will produce fewer goods and
therefore will demand fewer workers.

 Improvement in the current account. Higher rates will reduce spending on

imports, and the lower inflation will help improve the competitiveness of
exports.

As a result, people start spending less because higher interest rates mean higher
borrowing costs. The demand for goods and services will drop, and inflation will
fall.

Effect of higher interest rates – using AD/A

S diagram.
Evaluation of higher interest rates
 Higher interest rates affect people in different ways. The effect of higher
interest rates does not affect each consumer equally. Those consumers with
large mortgages (often first time buyers in the 20s and 30s) will be
disproportionately affected by rising interest rates. For example, reducing
inflation may require interest rates to rise to a level that causes real hardship
to those with large mortgages. However, those with savings may actually be
better off. This makes monetary policy less effective as a macroeconomic
tool.

 Time-lags. The effect of rising interest rates can often take up to 18 months
to have an effect. For example, if you have an investment project 50%
completed, you are likely to finish it off. However, the higher interest rates
may discourage starting a new project in the next year.
  It depends upon other variables in the economy. At times, a rise in
interest rates may have less impact on reducing the growth of consumer
spending. For example, if house prices continue to rise very quickly, people
may feel that there is a real incentive to keep spending despite the increase
in interest rates.

 Real interest rate. It is worth bearing in mind that the real interest rate is
most important. The real interest rate is nominal interest rates minus
inflation. Thus if interest rates rose from 5% to 6% but inflation increased
from 2% to 5.5 %. This actually represents a cut in real interest rates from
3% (5-2) to 0.5% (6-5.5) Thus in this circumstance the rise in nominal
interest rates actually represents expansionary monetary policy.

 It depends whether increases in the interest rate are passed on to consumers.

Banks may decide to reduce their profit margins and keep commercial rates
unchanged.

 Expectations. If people expect low-interest rates and they rise unexpectedly,

it may cause people to find they can’t afford mortgages/loans. The concern
is that after several years of zero interest rates – people have got used to low
rates.

Conclusion:
Interest rate has greater impact causing inflation and recession in a
country that effects consumer spending.