How a Rise in Interest Rate Could Cause a Recession
Analyse how a rise in the interest rate could cause a recession.
Macroeconomic Factors and Policies
CIE June 2021
(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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