In a recession, the central bank cuts its interest rate.
A rate cut, step by step
Rate cut
The central bank lowers its interest rate.
Cheaper loans
Mortgages and business loans cost less; saving pays less.
More C and I
Households spend more; firms invest more.
AD right
Real GDP rises and unemployment falls.
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In a boom, it raises the rate to bring inflation down.
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The points to remember
- Write it like this: "Higher interest rates raise the cost of borrowing, so consumption and investment fall and AD shifts left."
- Monetary policy shifts AD, not AS.
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The same change runs through the whole economy.
A rate rise and the circular flow
Investment falls
Firms borrow less to buy machines: an injection falls.
Saving rises
Households save more of their income: a leakage rises.
Less spending
Less income flows from households to firms.
A smaller flow
National income and output shrink.
The points to remember
- Higher rates can also attract money from abroad: the currency appreciates, so exports fall.
- Lower rates do the opposite: the currency depreciates and exports rise.
Remember it as: Rates up: less borrowing, less spending, AD left.
Paper 1 asked this in May 2024, as part (a) for 10 marks.
Explain how a decrease in interest rates is likely to affect the equilibrium level of national income.
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How the 10 marks are given
| Marks | What your answer needs |
|---|---|
| 9–10 | Theory fully explained, terms used correctly all the way through, the diagram included and fully explained |
| 7–8 | Theory explained, terms mostly right, the diagram included and explained |
| 5–6 | Theory partly explained, some terms, the diagram included |
| 1–4 | Theory only described or stated; few relevant terms |