Does Reducing Interest Rates always stimulate short term Economic Growth?

Consumption and investment are both major components of Aggregate Demand accounting for almost 80% Aggregate Demand. An important determinant of the AD components value is interest rates which is controlled by the Independent Bank of England using monetary tools. Low interest rates encourage consumers to borrow money from banks due the cheaper cost of repayment, this extra money makes consumers feel wealthier (wealth effect) therefore they’ll be willing to buy more goods from the Market. This causes the AD curve to shift to the right where there is a higher price level, inflation.


Similarly a reduction in interest rates will encourage firms to take out loans, as again the repayment cost will be lower. IN addition lowering interest rates will reduce the incentive of firms to keep money in Banks as the rate of returns will be lower. This money is invested in capital and training of existing and new staff so inefficiency can be decreases. This is shown on the graph below. The productive potential of the economy moves from Point A to Point B, which is closer to the PPF, where ideally where firms and the Country should be operating at.

Cheaper loans are ideal for business confidence s they reduce total cost which is very important for the profit maximising firms which exist in the Capitalist world. This is because cheaper cost will raise the profitability profile of potential business opportunities (Profit= Revenue - Total Cost). This surge of new investments will shift the AD curve to the right, also because of the multiplier effect the curve will shift even further than anticipated. (Multiplier Effect – Initial change in AD causes a greater final impact on the level of national income).

However surely it’s idiotic to believe that a simple change in interest rates will always stimulate short run Economic growth. This has been demonstrated quite well in our economy, the Bank of England committee set interest rates to record low figures. But despite this there wasn't much economic growth and this premature reduction prevented further reduction in the future that could've actually resulted in growth.

Another reason why I fail to agree is because if the interest rate is reduced dramatically consumers won’t be able to respond if they aren't made aware (Information failure) n. Also consumers and firms won’t respond to the reduction tot the reduction if it’s not significant enough and the interest rate is still relatively high. For example if it was cut by only 0.1% to 4.75%, this may not be enough of an incentive for firms and households to take risks on their future capability to pay it back. Also the interest rates set by the Bank of England for high street banks who might decide not to pass these savings onto potential customers to increase their profit margins for its shareholders.

In addition, a fall in interest rates may not always result in short run economic growth of other AD components change. For Example consumption and investment may increase, but this might be countered by a dramatic fall in net exports, which could happen if the newly acquired loans are used to purchase import goods. This will reduce the x-m figure and cause the AD curve to shift to the left if the change is significant enough. This will actually result in a short run decline, not the intended growth.

There are circumstances in which a drop in interest t=rates will result in growth but id largely depends on the position i which the economy is operating on the AD/AS curve. In this example growth has occurred (Y1 to Y2) as the economy isn’t at its optimum, so the price isn’t at its optimum so the price level P1 remains relatively constant, with no inflation occurring. However if the AD curve was originally at AD3, then an increase to AD4 will produce virtually no economic growth but will cause inflation, as the price level rises from p2 to p3.

A fall in interest rates may cause business confidence to increase as profit expectations will be higher. Due to this more investments will occur which will stimulate growth by raising national output and decreasing unemployment. This is most likely to occur if it happens in conjunction with improved tax policies (from firm perspective) and less government market intervention which can result in Government failure. One example of this is the excessive health and safety rules.

In conclusion i strongly believe that reducing interest rates won’t always result in a rise in economic growth due to the complexity of the economy. Therefore it’s wrong to be absolutely certain about economic policies because of this.