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Analyse how a rise in the interest rate could cause a recession.

Quick Answer:

Coherent analysis which might include: A higher interest rate would increase the cost of borrowing (1) reduce borrowing (1) reduce the spending power of people who have borrowed in the past (1) increase saving (1) consumer expenditure / spending may fall (1) investment may fall / may discourage MNCs (1) unemployment may increase / employment may fall (1) total demand may fall (1) the output of goods and services / GDP may fall (1) if output falls over a period of two quarters / six months there will be a recession (1). A higher interest rate may encourage more people to buy the currency (1) to put money into the country’s financial institutions (1) raising the value of the foreign exchange rate (1) raising the price of exports (1) lowering demand for exports (1) reducing the price of imports (1) increasing demand for imports (1).

Interest rate is the cost of borrowing money. A rise in interest rate is part of contractionary
monetary policy where the government wants to decrease the inflationary gap in the
economy. By increasing interests, the cost of borrowing increase for consumers and firms,
who are likely to reduce consumption and investment in the economy. As the rate of
interest rise, consumers borrow less reducing their spending expenditure. They are also
likely to save more as a result of a higher rate of return. Firms and MNCs would reduce
their investments as the cost of borrowing has increased. As a result of a fall in consumption and investment, aggregate demand will fall. As firms produce less output, they would
require less workers and unemployment will increase. If a fall in real GDP lasts for 6
months or more, the economy goes into a recession. Similarly, a rise in domestic interest
rates relative to foreign interest rates will attract foreign investment as the return on
money is higher. This will increase demand for domestic currency and cause appreciation
of the exchange rate. Appreciation however, makes domestic exports more expensive raising
their price and reducing demand, and imports become cheaper leading to a fall in net
exports. This further reduces aggregate demand and real GDP causing the economy to
go into a recession.

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