Interest rates

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Most companies have to borrow money from a bank at some point to pay for new buildings or machinery. When they pay this money back they have to pay extra on top of the amount of money they have borrowed; this is called the interest and it is how banks make money. For example if a business borrowed £100 and the rate of interest was 10%, it would have to pay back £110 (£10 is 10% of £100). The rate of interest is set by the Bank of England.

If the interest rate goes up the amount of money a business has to pay back on any loans it has will increase. This will means that its costs go up. On the other hand its costs will go down if the rate of interest falls because it has to pay less money back on the money it owes.

Businesses will also be affected by how consumers react to changes in the rate of interest. When people buy a house they will borrow money to pay for it, this loan is know as a mortgage. If the rate of interest goes up, consumers will have to pay back more money on their mortgage so they will have less to spend on goods and services. This will mean businesses sales will fall.

When consumers buy expensive goods they will sometimes take out a loan to pay for it. If the rate of interest goes up the repayments on this loan will also go up meaning that people are less likely to buy expensive products. This will lead to a fall in sales.

If the rate of interest goes down, businesses’ sales will often rise because:

people have more money because their mortgage repayments fall;
consumers are more willing to take out loans because they amount they have to pay back has gone down.

The amount of money businesses invest will also depend upon the rate of interest. Many businesses need to borrow money to invest in new buildings, machinery etc. If the rate of interest goes up it will become more expensive to borrow money, therefore the business is less likely to think it is worth doing. If the rate of interest falls, it becomes cheaper to borrow money meaning the business is more likely to carry out the investment project.

The rate of interest will also affect the value of the exchange rate. If the Bank of England puts up the rate of interest investment firms around the world will want to invest their money in the UK so they can earn a better rate of return. This will lead to money being moved into the UK. Investment firms will need to change their money into pounds before they can invest it in the UK. This increase in demand for pounds will lead to the pound become stronger or appreciate.

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