Write an account of the causes
and effects of an increase in the Rate of Interest
The rate of interest is
the price of capital. If money is deposited in a bank or building society
the depositor is rewarded with a payment of interest. The interest rate
is referred to as the reward for surrendering liquidity.
2. Causes of an Increase
in the Rate of Interest
An investor who wishes
to expand their business will probably ask the bank for a loan. If the
loan is granted it will have a price tag. The bank will charge a rate of
interest since it is surrendering capital to the entrepreneur.
A number of factors cause
the rate of interest to increase, as below.
3. Effects of an Increase
in Interest Rates
On 1 January 1999 Ireland
joined the Economic and Monetary Union (EMU). From that date the European
Central Bank (ECB) became the governing authority of Irelandís monetary
policy. All references to money and interest rates should be seen in this
If the ECB decides to pursue
a restrictive monetary policy then part of that action may be to raise
interest rates to discourage borrowing as a deflationary measure.
The money supply is a pool
of money available to both the public and private sector to finance their
commitments. If governments exert a high level of pressure on this finite
supply to the extent that demand exceeds supply leading to an increase
in interest rates.
If international rates,
such as in the USA, increase then the European Central Bank will be forced
to raise rates in order to counter an outflow of funds.
If inflation is greater than the rate of interest pressure will be exerted
to raise interest rates to protect the value of money.
Savings are encouraged because
of greater returns on deposits
Borrowing is discouraged having
a deflationary effect
Reduced borrowing leads to
a reduction in imports
There will be an inflow of
funds from abroad
Investment is discouraged because
of the increase increased price of borrowing
Aggregate demand will fall
because of the decline in investment
The reduction in aggregate
demand could lead to an increase in unemployment
Home owners will have to pay
higher charges on their loans