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How a Rise in Interest Rate Could Cause a Recession

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

Category:

Macroeconomic Factors and Policies

CIE June 2021

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Answer

Tip : This essay requires to be clearly structured as all paragraphs are linked to each other.

(STEP 1: DEFINE THE INTEREST RATE and A RECESSION)




Interest rate is the cost of borrowing money.

A rise in interest rate can cause a recession as it can cause a fall in a country's gross domestic products and it's components. Gross domestic product (GDP) measures the monetary value of goods and services produced within a country for a given period of time, usually one year.

The components of GDP are consumption expenditure (C) , Investment expenditure (I) , Government expenditure (G) , Export (X) earnings and imports earnings (M).

GDP = C + I + G + ( X - M)

A recession occurs in the business cycle when there is a fall in GDP for two consecutive quarters.






(STEP 2: EXPLAIN IMPACT OF A RISE IN INTEREST RATES ON BORROWING, SAVING AND SPENDING)




🏦A rise in interest rates can cause a recession because it decreases borrowing and increases saving. This leads to a fall in spending and investment.

When the rate of interest is increases, the cost of borrowing increases for consumers and firms.
When the cost of borrowing increases, consumers borrow less and reduce their spending expenditure. A rise in interest rate also reduces the spending power of people who have borrowed in the past.
Consumers are also likely to save more as a result of a higher rate of return. Overall, consumption expenditure will fall. Firms and MNCs would reduce their investment expenditure as the cost of borrowing has increased. All these factors will cause the gross domestic product (GDP) to fall. If a fall in real GDP lasts for two consecutive quarters, the economy goes into a recession.






(STEP 3: EXPLAIN HOW A FALL IN CONSUMPTION AND INVESTMENT DUE TO A RISE IN INTEREST RATES RESULTS IN A RECESSION)




🏦A rise in interest rates can cause a recession because it leads to a fall in Consumption (C) and Investment (I), which are components of GDP.

By increasing interests, the cost of borrowing increase for consumers and firms, who are likely to reduce consumption and investment in the economy. As a result of a fall in consumption (C) and investment (I) , aggregate demand will fall.

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The diagram above illustrates how a rise in the interest rate could cause a recession.

Higher interest rates will tend to reduce consumer spending and investment. This will lead to a fall in Aggregate Demand from AD to AD1. As firms produce less output, they would require less workers and unemployment will increase. All these factors will cause the gross domestic product (GDP) to fall from Y to Y1. If a fall in real GDP lasts for two consecutive quarters, the economy goes into a recession.





(STEP 4: EXPLAIN HOW THE IMPACT OF A RISE IN INTEREST RATES ON IMPORTS AND EXPORTS RESULTS IN A RECESSION)






🏦A rise in interest rates can cause a recession because it impacts Imports (M) and exports (X), which are components of GDP.

A rise in domestic interest rates relative to foreign interest rates will attract foreign investment as the return on is higher. This will increase demand for domestic currency and cause appreciation of the exchange rate.
Appreciation however, makes domestic exports more expensive and this reduces demand. 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.




To conclude, a rise in interest rate can cause a recession as it can cause a fall in a country's gross domestic products and it's components.







>MARKING SCHEME<

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).

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