How the bank of engalnd controls base rate by raising interest rates

 

 

 

When the Bank of England raises its base rates, it aims to control inflation by influencing the cost of borrowing in the economy. Here's how it works:

1. Impact on lending rates: The base rate is the interest rate at which the Bank of England lends money to commercial banks. When the base rate is increased, commercial banks face higher borrowing costs. To maintain their profit margins, they pass on these higher costs to their customers in the form of higher lending rates, such as mortgage rates, personal loan rates, and business loan rates.

2. Reducing borrowing and spending: Higher lending rates make borrowing more expensive for individuals and businesses. As a result, the demand for loans decreases, leading to reduced borrowing and spending. When people and businesses are less likely to take on new debt or make large purchases, it can slow down the overall economic activity.

3. Decreased money supply: When borrowing and spending decrease, the overall money supply in the economy tends to contract. This reduction in the supply of money can help dampen inflationary pressures. With less money available for spending, there is less upward pressure on prices.

4. Impact on savings and investment: Higher interest rates make saving more attractive to consumers and businesses. Increased returns on savings can incentivize people to save more, which reduces their disposable income available for consumption. This, in turn, can moderate inflationary pressures as spending is curtailed.

5. Exchange rate effects: When interest rates rise, it can make the currency more attractive to foreign investors seeking higher returns on their investments. This increased demand for the currency can lead to an appreciation of the exchange rate. A stronger currency can lower the cost of imported goods and services, thereby reducing inflationary pressures.

Overall, by raising the base rates, the Bank of England seeks to make borrowing more expensive, reduce borrowing and spending, decrease the money supply, encourage saving, and potentially strengthen the currency. These measures aim to moderate inflation by reducing the overall demand and supply of money in the economy.