Evaluating interest rates as a policy tool

Overview

The lags, the blunt reach across the whole economy, the zero lower bound, and the cases where a rate change achieves less than intended.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Give two strengths of interest rates as a macroeconomic policy tool.

   Model answer

   Bank Rate can be changed quickly and reversed if conditions alter. Decisions are taken by an independent committee free from electoral pressure.

2. 2

   Why is monetary policy described as a blunt instrument?

   Model answer

   A change in Bank Rate affects every region and every sector at once. Policy cannot be aimed at an overheating housing market alone.

3. 3

   Why do interest rate changes affect households unevenly?

   Model answer

   Borrowers lose from a rate rise while savers gain. Younger mortgage holders bear far more of the burden than outright owners.

4. 4

   Why may a rate cut fail to raise borrowing in a recession?

   Model answer

   Households and firms will not borrow when they expect incomes and profits to fall. Confidence matters more than the price of credit in a slump.

5. 5

   Why may banks fail to pass a rate cut on to borrowers?

   Model answer

   Banks rebuilding their capital widen the margin between Bank Rate and lending rates. The rate a customer actually faces then barely moves.

6. 6

   What limits monetary policy at the zero lower bound?

   Model answer

   Bank Rate cannot fall far below zero without driving savers into banknotes. The Bank of England must then turn to quantitative easing instead.

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