2.1.2 - Monetary policy and interest rates

Interest rates and central banks

An interest rate expresses the price of borrowing, or the return from saving, as a percentage over a stated period.

Interest is the payment made for using borrowed funds. The borrower pays it in addition to returning the principal, the original amount borrowed. A saver may receive interest for depositing money. A rate of 5% per year means £5 annual interest per £100 under a simple one-year arrangement; it is not a £5 payment regardless of the amount saved.

Monetary policy is the use of monetary measures, particularly interest-rate changes, to influence spending and macroeconomic conditions. A central bank sets a policy or base interest rate and uses its operations to influence rates in financial markets. Commercial banks then decide their own savings and lending rates. These need not equal the policy rate: lenders also consider risk, costs and competition. Existing fixed-rate loans may not change immediately.

Central banks commonly use rates to pursue price stability. Higher rates can restrain spending when demand is generating excessive inflation; lower rates can encourage spending when weak demand threatens output and jobs. They consider expected conditions because policy takes time to work. Raising the policy rate does not mechanically reduce every shop price tomorrow, and monetary policy does not directly set a tax or a government spending budget.

Saving, borrowing and household spending

A change in rates affects both the incentive to save and the cost of borrowing, so households respond differently.

For simple interest, no interest is added to the principal during the period:

With illustrative savings of £2,500 held for one year at 4%, interest is £2,500 × 0.04 = £100 and the final balance is £2,600. At 6%, interest would be £150 and the final balance £2,650. The rate has risen by 2 percentage points. The interest payment has risen by 50% because (£150 − £100) ÷ £100 × 100 = 50%. Do not confuse these two changes. If interest is paid into the account and itself earns interest in later years, that is compound interest; use the terms supplied rather than silently assuming compounding.

Higher rates make postponing spending more attractive because saving earns a greater return. They also increase interest on new borrowing and on existing variable-rate debt. For example, a household with an unchanged £10,000 loan balance pays £400 annual interest at 4%, but £600 at 6%, under a simple interest-only illustration. The extra £200 can reduce the income available for other purchases. Actual repayment loans also repay principal and follow their contract; this example isolates the interest effect.

Lower rates reverse these incentives: saving yields less and credit becomes cheaper, encouraging spending on items such as cars or appliances. Existing fixed-rate borrowers respond later when their contract ends. A household with substantial savings may instead spend some of its higher interest income when rates rise. These different effects explain why “every household spends less” is too strong. The expected overall restraint comes from incentives and debt costs across the economy.

Business investment and macroeconomic effects

Businesses respond to interest rates through their financing costs and through changes in customer demand.