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Bank of England base interest rate, 2016–2020 (a) With reference to the chart above, explain the likely impact of a reduction in the base interest rate on UK investment - Edexcel - A-Level Economics A - Question 3 - 2022 - Paper 2
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Bank of England base interest rate, 2016–2020 (a) With reference to the chart above, explain the likely impact of a reduction in the base interest rate on UK invest... show full transcript
Worked Solution & Example Answer:Bank of England base interest rate, 2016–2020 (a) With reference to the chart above, explain the likely impact of a reduction in the base interest rate on UK investment - Edexcel - A-Level Economics A - Question 3 - 2022 - Paper 2
Step 1
With reference to the chart above, explain the likely impact of a reduction in the base interest rate on UK investment.
Answer
A reduction in the base interest rate is likely to have a substantial positive impact on UK investment. Firstly, when interest rates decrease, the cost of borrowing money becomes lower. This encourages firms to take loans for expansion or other investment opportunities.
In 2020, the base interest rate fell sharply from 0.75% to just 0.10%, representing a significant reduction (0.65 percentage points). This substantial drop would have incentivized firms to seek financing for investments as the reduced borrowing costs create more favorable economic conditions.
Moreover, lower interest rates generally instill greater confidence among businesses. When firms are feeling optimistic about the economic environment, they are more willing to invest. As investment increases, it can lead to greater production capabilities, potential job creation, and stimulate overall economic growth.
Additionally, reduced interest rates lower the cost of production for firms, enhancing profitability. If borrowing becomes less risky under these conditions, firms are more likely to shift their focus toward growth strategies.
In summary, a decrease in the base interest rate leads to a stimulating effect on UK investment through lower borrowing costs, increased confidence among firms, and improved profitability.
Step 2
Which one of the following would be most likely to result from lower base interest rates?
Answer
The correct answer is B: the external value of the pound.
Lower base interest rates usually lead to a depreciation of the currency because they can reduce the attractiveness of the currency for foreign investors seeking higher returns. With lower interest rates, the demand for the currency may decrease, hence lowering its external value.
Options A, C, and D are incorrect:
- A is incorrect because average house prices would likely rise as decreased interest rates make borrowing cheaper, encouraging more buyers.
- C is incorrect because lower interest rates typically do not lead to a decrease in employment; in fact, they can stimulate job growth.
- D is incorrect because lower base interest rates are likely to increase economic growth rather than decrease it.