Discuss the Extent to Which a Reduction in the Rate of Interest Can Be Effective in Increasing Consumer Expenditure and Investment

960 Words Mar 13th, 2015 4 Pages
The definition of consumer expenditure is the amount of money spent by households in an economy. The definition of investment is the spending by firms on capital good such as new machines etc. Finally the definition of interest rates is the proportion of a loan that is charged as interest to the borrower, normally expressed as an annual percentage. In the UK the interest rates are set by the Monetary Policy Committee and are usually used in order to influence levels of aggregate demand. Primarily, you must understand that lowering the rate of interest will make it cheaper for people to borrow as well as make it cheaper to pay back existing loans. As a result, firms may use this money that they have saved to spend on upgrading the …show more content…
Furthermore, if the interest rate was low before the cut then it may not appear to have a very big impact because people will have already have been taking advantage of the small cost of borrowing. Obviously if the interest rate was very high discouraging people from borrowing and in turn reducing consumer expenditure and investment by firms, then a rapid cut could see a high rise in the aggregate demand. Moreover, if someone is in the middle of paying back a mortgage on something like a house and interest rates fall they will effectively have more money because they will not be paying more on top of their mortgage on interest.

On the other hand, the reasons for increases of consumer expenditure and investment levels as mentioned above are only all valid if ceteris paribus is assumed. In reality, both factors of aggregate demand can be affected by multiple other external factors for example, consumer expenditure can be affected by the marginal prosperity to consume amongst consumers and therefore if this is very low then a cut in interest will see a minimal change in consumption and investment levels. In terms of consumers and firms if a large cut were to occur it would have a far superior effect in comparison to a small cut which could potentially have no impact. As well as this it can also be affected by the Income Elasticity ofDemand this means the responsiveness of the demand for a good to a change in