My Year 11 groups are looking at the management of the economy this week and have been asked to assess the effectiveness of fiscal and monetary policy in stimulating demand in the economy. Quite a big question, since that is exactly the one which is exercising the likes of Gordon Brown, Alistair Darling and Mervyn King.
Today we got to the point where we had traced through the impact of lower interest rates on the economy - the monetary transmission mechanism. OK, so that makes it all very simple we thought. That should mean that the Fed's latest interest rate cut (which brings US interest rates down to 1%) and the much anticipated cut in the Bank of England's Base Rate (some think as much as 1% will be lopped off the Base Rate) should give a welcome boost to demand.
But these cuts in interest rates just aren't getting through to households and firms who. in some cases, are paying higher interest rates than they have done in the past. So why when the Base Rate of interest is coming down are market rates of interest going up?
The answer lies in our attitude to risk. Lending money to anyone is now much riskier than it has been. So the rate at which banks lend to each other has risen (so-called interbank rates) and the rates they offer to savers has gone up to try to plug the hole in the bank's balance sheets. Look at the chart at the top of this post to see what is going on. Down really does mean up.
Watch this space as the Bank of England decides what should happen to UK interest rates this Thursday. In the meantime you might like to read some of the recent articles listed below.
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