Commenting on the Bank of England's decision to raise the interest rate, Dr Mohammad Mahbubur Rahman, Lecturer in Economics, University of Salford Business School, said: “The Bank of England has announced a further lift in interest rates for the tenth consecutive time, taking it to a 14 year high of 4%. On the current trajectory, it could reach its expected peak of 4.5% in the summer.
“The bank rate positively affects both borrowing and lending interest rates in commercial banks, as they borrow money from the central bank at the current rate. Now the question is, how will the economy be affected by rising interest rates? According to the IS-LM (investment-savings, liquidity preference-money supply) model, the real gross domestic product (GDP) will grow if the real interest rate, which is the nominal interest rate minus the inflation rate, increases. However, we’ve seen the real interest rate decline as the inflation rate increased more rapidly than the nominal interest rate. Currently, the UK’s real interest rate is negative, as it is in the US. So, according to the model, it’s clear economic growth will be slower and most likely to be negative. Why? Because consumers will delay buying items deemed a luxury (such as cars, houses, etc.) and investors will delay expanding businesses. Bankers will also be more reluctant to give loans, as the negative real interest rate means negative profit for them.
“In line with negative real interest rates, governments also typically have a tendency to increase the bank rate further so that the real interest rate turns positive. The positive is then more likely to result in future higher economic growth. During times of recession, just focusing on the monetary policy will be less effective in recovering the economy if increases in inflation rate cannot be stopped. This should be done by raising the aggregate supply of outputs. Then, once the inflation rate falls, the nominal interest rate will fall in tandem. This will also alleviate the pressure on households and property owners, as mortgage payments will be reduced; while there will be more confidence amongst business leaders. The ultimate outcome is future higher economic growth, which will benefit the wider UK population.”