LEARN IT WELL_Evaluate interest rate policy _interest elasticity 2011JC2 MJC ECONOMICS �

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Y1 Y2

ANALYSING HOW A REDUCTION OF THE INTEREST RATE WILL HELP ACHIEVE ECONOMIC GROWTH Reducing interest rates A reduction in interest rate will lower the cost of borrowing, which increases the amount available to spend after people have paid less for loans that have variable interest rates. Hence, this will increase consumer spending on housing and other consumer durables. A fall in interest rate will also increase investment. This is because the lower cost of borrowing � assuming expected yield no change � expected yield > cost of borrowing � profitability of investment will increase. Firm will also increase investment because they expect the demand for goods bought on credit to rise when the cost of borrowing decreases. The increase in both consumption expenditure and investment expenditure will cause AD to increase from AD1 to AD2 in the diagram below, and hence promote actual growth depicted by an increase in real national output from Y1 to Y2 via the multiplier process. A fall in interest rate may also cause hot money to flow out of the country due to the lower rate of returns on the short term capital. Demand for the country’s currency will fall, causing the country’s currency to depreciate. A lower exchange rate will make the country’s exports cheaper in foreign currency and imports dearer in domestic currency. Demand for exports increases, hence export revenue and AD will rise, thereby raising economic growth in the country. Assuming PED m > 1, Qty DD for M will fall more than proportionately hence M exp falls � Assuming same level of income � households switch to buying relatively cheaper domestic goods � Cd increases � reinforce the increase in AD.

A reduction of the interest rate will help to achieve economic growth

A

General Price Level

Real National Output

AD1

Diagram 1: Expansionary Monetary policy

O

AS1

P1

P2

AD2

N.B. No need to quote marshall lerner condition here � analyzing the individual effects of X, M and Cd. We are not analyzing the net effect of (X-M)

LEARN IT WELL_Evaluate interest rate policy _interest elasticity 2011JC2 MJC ECONOMICS �

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The higher the interest elasticity of demand for investments, the more successful would a reduction in interest rate be in achieving economic growth.

The relationship between interest rates and the volume of investments can be represented using the MEI (Marginal Efficiency of Investment) curve, which shows the different volumes of investments that would be undertaken at various interest rates. The MEI curve is downward sloping, reflecting the inverse relationship between interest rates and the volume of investments.

The interest elasticity of demand for investments would vary depending on the type of investment in question. In the case of FDI, the volume of foreign direct investments would not be affected by changes in the domestic interest rates, as the foreign firms would tend to borrow from banks in their own country, rather than from domestic banks. Hence, in the case of FDI, demand tends to be interest inelastic. Another factor that may make interest elasticity of demand for investments higher would be positive business expectations.

With demand for investments being interest elastic (MEI 1), a fall in interest rates from I/r 1 to I/r2 will lead to a more than proportionate increase in the volume of investments from Q1 to Q2. Hence, this would mean a larger increase in Investments and AD, increasing economic growth to a large extent. Conversely, if demand for investments was not responsive to changes in interest rates (MEI 2), a fall in interest rates will only cause a less than proportionate increase in the volume of investments from Q1 to Q3. This thus limits the increase in I and AD, limiting the increase in economic growth.

MEI1

EVALUATION OF ARGUMENT: COMMENT ON LIMITATIONS OF THE POLICY

Interest rate

Vol of investment

MEI2

I/r 1

I/r 2

Q1 Q3 Q2