Unit 25 The Impact of Interest Rates

Key Terms Interest Rates – the percentage reward or payment over a period of time that is give to savers or paid by borrowers on savings or loans. Bank Of England – the central bank for the UK. Its role is to monitor the banking system and to be a banker to the banks. It is responsible for setting interest rates in the UK. Variable Interest Rate – an interest rate that can change over the period of the lifetime of the loan depending on what is happening to other interest rates in the economy. Fixed Interest Rate – interest rate that stays the same over an agreed period of a loan.

Credit Credit is simply the term given to the ways that a business can borrow money. Businesses need to borrow money for different reasons:- It may have long term loans to help pay for equipment (loans taken out over a period of longer than 1 year), Or the business may run an overdraft, this allows the business to use money that it does not have at the time. It is good business practice for a small business to use loans to buy equipment and finance longer-term expansion. Overdrafts should be used to cover short term changes in cashflow and sudden unexpected bills

The Cost Of Borrowing Banks charge interest on the money they lend out. Interest is the price that has to be paid to borrow money and interest rates show the money that has to be paid back. For example if a bank charges 10% interest a year to borrow money on an overdraft, this means that if you borrow £1,000 then you have to pay back an extra £100. Since many businesses have loans and overdrafts the rate of and amount of interest is an important consideration.

Interest Rates Interest rates can change. For borrowers the higher the rate of interest the higher the amount that has to be paid back, equally, if the interest rates fall then the business has less interest to pay. Rises in the interest rates mean more to pay for loans, and as a result the total costs of a business will increase leading to less profit. Falls in interest rates mean less to pay for loans, and as a result the total costs will fall, leading to more profit.

Variable Rates of Interest The interest rate on bank overdrafts usually changes over the year. This means that those interest rates are variable rates. Bank overdraft rates tend to be set by the Bank of England. It uses changes in interest rates to control inflation – the rate of changes in prices in the economy. With variable interest rates it is difficult for businesses to predict exactly the cost of borrowing. Large variations mean bigger costs, smaller ones mean smaller costs.

Fixed rates of Interest The interest rates on loans may vary too, however, many loans to small businesses carry fixed interest rates. This means that the rate of interest on a loan does not change whilst the loan is being repaid. If the rate of interest were 8% on a loan for 2 years, then it would stay at 8% and not change. This makes it easier to predict the cost of borrowing and the costs of the business.

The Bank Of England The interest rate that a business has to pay is affected by the interest rate set by the Bank Of England. The Bank of England is called a central bank. It acts as a banker to all the banks. It has a committee called the Monetary Policy Committee (MPO) that set the interest rates it will charge to lend money to other banks. This interest rate affects interest rates through the banking system. If the Bank of England increases interest rates then the other banks will do the same. If it reduces the interest rates then the banks usually do the same.

Interest rates and consumer spending Consumers are people (not businesses). Consumers, like businesses borrow money for different things, may be a house, a new car, a holiday or new furniture. At Christmas consumers may use overdrafts, or credit cards to pay for presents. When interest rates go up, this makes the cost of borrowing more expensive and so consumers will be put off spending or not have as much ‘spare’ money to spend. If consumers are put off spending this means that business do not sell their products and so they have less money. Firms that sell products that of highly priced or seen as luxury items can really struggle if interest rates are high.

As a Side Point.... What is happening in the economy at the moment? Boom or Bust? Spending or Saving? Government? Recession? Down turn? Redundancy or Employment? Before the SUMMARY – use the cards and match up the statements.

Interest rates go upInterest rates fall..so.. businesses have to pay more interest on their loans businesses have to pay less interest on their loans..so.. Businesses decide not to invest in new machines Businesses decide to invest in new machines..so.. Households decide to save more and spend less Households decide to save less and spend more..so.. Spending in the economy falls. Some businesses fail Spending in the economy rises. Some businesses expand. …and.. Households are put off borrowing money Households are more keen to borrow money…and.. Households have to pay more on their mortgage and have less to spend on luxuries Households have to pay less on their mortgage and have more to spend on luxuries …and..

Homework Unit 25 - Homework

Kagan tasks.