Why change the interest rate?

When the Bank of England changes the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation. A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased. Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad. Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers’ expectations of inflation – an important consideration for the eventual settlement. The impact on output and wages feeds through to producers’ costs and prices, and eventually consumer prices and therefore inflation.