2.5 - Interest and Inflation Rates Flashcards
What do interest rates determine?
Interest rates determine the cost of borrowing and the return on savings.
How do interest rates affect borrowing and saving?
Borrowing: Interest is the percentage charged on borrowed money. A fall in interest rates decreases borrowing costs, while a rise increases them.
Saving: Interest is the percentage paid by banks on savings. A fall in interest rates decreases the return on savings, while a rise increases it.
How does the Bank of England base rate affect interest rates?
The Bank of England sets the base rate, influencing commercial banks’ interest rates, although banks can adjust their rates independently.
How do interest rates affect business costs?
If a business has a loan or mortgage, a rise in interest rates increases repayment costs, whereas a fall reduces them.
How do interest rates affect consumer spending and businesses?
High interest rates: Consumers have less disposable income (especially those with loans/mortgages), reducing demand. Savings become more attractive, further lowering spending.
Low interest rates: Consumers have more disposable income, increasing demand. The lower reward for saving also encourages spending.
How does the effect of interest rates on demand depend on the product?
Expensive products that often require borrowing (e.g., houses, cars) are more sensitive to interest rate changes.
If interest rates rise significantly, firms may adjust strategies by diversifying into cheaper products.
What is inflation?
Inflation is the overall increase in the price of goods and services within an economy.
What are the two types of inflation?
Demand-pull inflation – When demand exceeds supply due to increased disposable income. Businesses raise prices due to high demand, potentially increasing profit margins.
Cost-push inflation – When rising costs (e.g., wages, raw materials) force businesses to increase prices. This can reduce profit margins if businesses don’t pass on the costs.
How is the rate of inflation calculated?
Inflation is measured as the percentage change in the price of goods and services over a year.
How can expectations of inflation worsen inflation?
Businesses expecting rising costs increase prices in advance.
Workers demand higher wages due to expected price increases.
Higher wages increase demand, further pushing up prices (wage-price spiral).
How does high inflation affect consumer spending?
Short term: Consumers may rush to buy goods before prices rise further.
Long term: If wages don’t rise with inflation, purchasing power decreases, leading to lower spending.
How does inflation affect UK businesses globally?
High UK inflation: Makes UK exports more expensive abroad, reducing competitiveness.
Low UK inflation: Gives UK businesses a competitive advantage internationally.
How does the Bank of England control inflation?
It adjusts the base interest rate to stabilize inflation within the target set by the government.
What is deflation?
Deflation is the overall decrease in the price of goods and services within an economy.
Why does deflation happen?
It occurs when demand is too low, causing businesses to reduce prices.
How does deflation impact businesses?
Falling demand reduces productivity, as businesses won’t keep producing unsold goods.
Lower productivity leads to job losses, increasing unemployment.
Unemployment causes further drops in demand, triggering more price reductions.
What is the Consumer Price Index (CPI)?
A measure of inflation that tracks the changes in the average cost of a basket of commonly purchased goods and services.
How is an index number calculated?
Indexnumber = (Averagevalueofthebasket ÷ Basevalueofthebasket) × 100
How do you use an index number to find the average value of the basket?
Averagevalueofthebasket = (Index number ÷ 100) x Base value of the basket
How does inflation impact premium product businesses?
Consumers may switch to cheaper alternatives if disposable income falls.
Businesses may reduce prices cautiously to maintain their premium image.
They may invest more in advertising to retain customer interest.
How can high inflation benefit businesses?
If interest rates are lower than inflation, businesses can borrow money cheaply for expansion.
Saving becomes less attractive, so businesses may invest rather than hold cash reserves.
How do UK businesses compare domestic and foreign interest rates?
When UK interest rates are high or unstable, firms may expand into countries with lower, more stable interest rates, as borrowing is cheaper there.
Why does high inflation make business planning difficult?
Businesses need stable prices to make accurate financial forecasts, budget effectively, and plan long-term strategies.
