Th2.6: Four Key Mechanisms

Question 1

What will the rise in interest rates increase and what will this lead to?

Answer 1

the cost of borrowing for consumers and firms, leading to a fall in investment and consumption, reducing AD

Question 2

What are two particular areas of consumption that will decrease?

Answer 2

consumer durables and houses

Question 3

What do higher interest rates require?

Answer 3

higher rates of return for investment

Question 4

How do higher interest rates make saving more attractive?

Answer 4

the interest earned on them will be higher

Question 5

Since less people are borrowing and more are saving, there is a fall in… leading to…

Answer 5

demand for assets such as stocks, shares and government bonds, leading to a fall in pricing for these assets

Question 6

Why will consumers experience a negative wealth effect?

Answer 6

due to the fall in price of assets - leading to a fall in consumption

Question 7

Moreover, why is investment less attractive?

Answer 7

firms are likely to see lower profits if prices fall

Question 8

What will happen to people’s confidence if interest rates rise?

Answer 8

less confident about borrowing and spending

Question 9

What will happen to other loans, such as mortgages and what will this do to consumers?

Answer 9

they will become more expensive to repay and so consumers have to dedicate more of their income to paying back these debts, decreasing consumption

Question 10

How will higher interest rates affect foreigners?

Answer 10

increase incentive for foreigners to hold their money in British banks as they can see a higher rate of return

Question 11

What will happen to the pound if more foreigners hold their money in British banks and what will this lead to?

Answer 11

increased demand for pounds, as the value of the pound rises - imports cheaper and exports more expensive - decreases net trade and therefore AD