If a central bank increases the base rate, this tends to increase all major interest rates in the economy. This means interest rates for both savers and borrowers will increase.
Higher interest rates will have various economic effects:
1. Increases the cost of borrowing. Interest payments on credit cards and loans will be more expensive. Therefore this discourages people from borrowing and saving. People who already have loans will have less disposable income because they spend more on interest payments. Therefore other areas of consumption will fall.
2. Increase in mortgage interest payments.Related to the first point is the fact that interest payments on variable mortgages will increase. This will have a big impact on consumer spending. This is because a 0. 5% increase in interest rates can increase the cost of a £100,000 mortgage by £60 per month. This is a significant impact on personal disposable income and will lead to lower spending in the economy.
3. Increased incentive to save rather than spend.Higher interest rates make it more attractive to save in a deposit account because of the interest gained from saving
4. Higher interest rates increase the value of exchange rate.For example, if UK interest rates increase relative to other countries, investors are more likely to save in British banks because they get a better rate of return. A stronger pound makes UK exports less competitive and imports cheaper. This reduces exports and increases demand for imports.
5. Rising interest rates affect both consumers and firms. Therefore the economy is likely to experience falls in consumption and investment.
6. Government debt interest payments increase.The UK currently pays over £40bn a year on its own national debt. Higher interest rates increase the cost of government interest payments. This could lead to higher taxes in the future.
7. Reduced Confidence. Interest rates have an effect on consumer and business confidence. A