Macro-Economic Policies

Interest rates, set by the Bank of England, were cut rapidly in Autumn 2008 from 5%, and fell to 1.5% by
January 2009. By the end of that year, rates had been cut to 0.5% and have remained at this level since, the
lowest rates ever.

a. What is meant by the term ‘interest rate’? (2 marks)

An interest rate is the charge made on a loan or other borrowing facility, this can be viewed as the
price for money. An interest rate is also a payment made by a bank or other savings institution to the
saver for the use of the money deposited in an account with them. Interest rates are usually a
percentage.

b. Explain three ways in which a large cut in interest rates might affect economic growth. (9 marks)

There are many ways in which a large cut in interest rates may affect economic growth. With lower
rates of interest, consumers may find it better to spend their income, as by saving it in a bank they will
get very little growth on their savings, as compared to higher rates of interest previously. It could also
encourage borrowing, as with lower rates of interest, less repayment is required on the loan. Both
consumers and businesses may wish to borrow more. Increased borrowing by consumers could lead
to a higher level of economic activity. Aggregate demand could increase. Firms may invest more
because it is cheaper for them to borrow in order to finance investment. However, a large cut in
interest rates could damage consumer confidence, causing them to feel that something is seriously
wrong with the economy and therefore make the decision not to borrow. A cut in interest rates could
also encourage consumers to spend more of their disposable income, therefore creating increased job
opportunities due to increased demand. Interest rates on housing mortgages are paid monthly and
depend on the level of interest rates. Lower interest rates will mean lower monthly repayments,
leaving consumers with higher disposable income, putting an increased pressure on inflation.

c. Interest rates are often increased to reduce the rate of inflation. Explain two reasons why the government
would want to reduce inflation. (6 marks)

The government may want to reduce inflation, in order to stop the economy going into an excessive
boom, followed by a downturn. They may also want to reduce inflation, in order to encourage
consumer spending. The lower inflation will keep prices lower, therefore encouraging consumers to
spend more. This will increase government revenue through VAT. Increase in government spending
could lead to higher levels of inflation. If the spending within the economy is already rising then and
extra spending by the government could seriously contribute to higher inflation. However, if spending
is not already high, then increases in government expenditure won’t have an impact on inflation.
Therefore, the government may wish to reduce expenditure so they can spend more. Inflation can
also create uncertainty for firms, and this may affect the level of investment as there is more of a risk.
Higher inflation could also make UK manufacturing uncompetitive, as UK products could be more
expensive than foreign alternatives. The higher the level of inflation, the less purchasing power a
consumer’s income has been reduced.

Macro-Economic Policies
Thomas Mercer
d. Interest rate reduction can help to reduce unemployment. Discuss the alternative methods a government
could use to reduce unemployment. (15 marks)

Interest rates are part of monetary policy. Two alternative policies include fiscal policy and supply side
policy. Fiscal policy can include changing and cutting benefits, creating a greater incentive to work, as
currently the benefits scheme is more appealing, and creates a higher income, than working. With
lower and more restricted benefits the option of working can seem more appealing, and create higher
income, than benefits. However, those who are unable to find employment could begin to experience
difficulties as they have less income due to fewer benefits available. They can also lower income
taxes, in order to create an even greater incentive to get back into work. In gaining employment, not
only are benefits taken away but an employee is also then required to start paying taxes. This could
leave them with a lower level of income than before. Therefore, income taxes for low wage earners,
could be significantly reduced, leaving them in a better state in employment than they were in
unemployment. Supply side policy can include creating increased training options, to make it easier to
enter into employment. The government could do this by lowering university course fees and
resuming EMA as an incentive to continue education. Also offering a wide range of alternative training
options for those who are not suited to a very academic style of learning could improve training in
areas that aren’t so academically based.

Macro-Economic Policies
Thomas Mercer