Profits in business always depend on the rate of interest: the higher the interest, the higher the rate of profit required."
- James Buchan
Interest rates are essentially the cost of borrowing money. As a result, when businesses borrow money, the reason they need to turn a higher profit is due to the interest payments they need to make on the borrowed money. Let's take a look at this concept in more detail.
Definition of Interest Rates
Interest rates can be defined as the cost of borrowing money.
When we (individuals) or firms borrow money, we have to pay a certain rate. However, if you deposit money in a bank you also receive interest on your deposit - the bank pays you interest when you store your money with them. In the UK, the Bank of England sets the base rate for interest. Currently, the official base rate in the UK is 0.1%.
If you borrow £ 1,000 from a bank and the base rate of interest is 0.1%, you would end up having to pay back £ 1,001. Similarly, if you deposited £ 1,000 you would receive £ 1,001 after a certain defined interest period.
Some common examples of where you would be charged interest are:
Factors affecting interest rates
Even though the Bank of England sets the base rate, many other factors could influence the actual rate of interest you are paying or receiving. For instance, if you are borrowing money, the rate of interest will depend on the term of the loan (how long it will take you to repay the money) and how risky the loan is. If there is a higher risk attached to your loan, then you will be charged a higher rate of interest. Credit risk comes from the borrower's perceived inability to repay the loan.
The base rate in the UK is currently quite low. It has been set at this low rate in order to encourage consumption and investment in the economy.
Monetary Policy and Interest Rates
Monetary policy is a type of government policy that influences an economy's interest rates or money supply to change the level of output in the economy.
The government can increase or decrease the rate of interest by changing the base rate of interest.
When interest rates are increased, it costs more to borrow money - so fewer people borrow. When interest rates are decreased, it costs less to borrow money - so more people borrow. This can directly impact a business's external environment.
A business's external environment includes many factors that the business does not have direct control over but can influence business decision-making (PESTLE).
Changes in Interest Rates
The influence interest rates will have on business decision-making depend on a couple of different factors.
Effects of an Increase in Interest Rates
If interest rates increase, people are less likely to borrow money. When interest rates increase, the cost of borrowing money is high but the return you get on saving money is also high. As a result, consumer spending on goods and services (consumption) will decrease - as people put off borrowing and save more. Investments will also decrease.
Small firms are often affected more by higher interest rates than larger firms. Small companies often rely more on borrowing money, as they have limited financial reserves. There is also a higher risk for banks when loaning money to a small firm, as they have fewer resources and assets - a higher possibility of them not being able to repay the loan. Substantial increases in interest rates could lead some smaller firms to bankruptcy.
Larger firms can also be affected by increases in the rate of interest. Like smaller businesses, large firms also borrow money, and often large amounts of it. If the company's rate of borrowing is high, a large increase in interest rates will lead them to have to pay large sums in interest payments. This could result in the businesses having to cut expenses in other departments, making them less competitive.
Finally, increasing interest rates also impact exchange rates. A higher interest rate in the UK will increase exchange rates, as more people and organizations try to buy GBP to profit from the high interest rate in the UK.
Effects of a Decrease in Interest Rates
If interest rates decrease, people are more likely to borrow money. When interest rates decrease, the cost of borrowing money is low but the return you get on saving money is also low. As a result, consumer spending on goods and services (consumption) will increase - as people are more confident in borrowing money and disincentivized from saving. Investments will likely also increase.
Similarly, a decrease in interest rates will also encourage business activity as investment increases. It becomes cheaper for firms to borrow money, reducing their expenses on interest payments, and increasing their investment in other departments or operations of the business. This could result in an increase in the competitiveness of the business.
Additionally, when interest rates are low, people are more likely to start new businesses - as the cost of borrowing money is lower.
Interest Rates in the UK - Key takeaways
Interest rates can be defined as the cost of borrowing money.
When individuals or firms borrow money, they have to pay a certain rate.
If you deposit money in a bank you also receive interest on your deposit - the bank pays you interest when you store your money with them
In the UK, the Bank of England sets the base rate for interest.
The official base rate in the UK right now is 0.1%.
Monetary policy is a type of government policy that influences an economy's interest rates or money supply to change the level of output in the economy.
When interest rates increase, the cost of borrowing money is high but the return you get on saving money is also high. As a result, consumer spending on goods and services will decrease and so will investment.
When interest rates decrease, the cost of borrowing money is low but the return you get on saving money is also low. As a result, consumer spending on goods and services will increase and so will investment.
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