The Effect of the Interest Rate Cut on the British Economy

In recent months, the Bank of England (BoE) has found itself at a critical crossroads. With inflation finally nearing its 2% target, policymakers are debating whether it’s time to ease up after a long period of monetary tightening. Intervention refers to actions taken by a central authority, such as the Bank of England, to correct market failures or stabilize the economy. The problem is high inflation in the UK due to rising oil prices in the UK due to conflicts in the Middle East , which has prompted the Bank of England to raise interest rates, leading to reduced consumer spending and business investment, resulting in slower economic growth. However, with inflation now nearing the BOE’s target of 2%, the central bank is considering intervention through interest rate cuts to stimulate aggregate demand, encourage spending, and promote economic growth. The lowering of the interest rates by the Bank of England from 5.25% to 5% has mixed effects on inflation and economic activity. 

Firstly, due to the rising oil prices driven by conflicts in the Middle East, the UK economy is experiencing cost-push inflation. This can be explained clearly through a diagram. Oil, being a crucial input in many industries, raises production costs across the economy, causing a leftward shift in the aggregate supply (AS) curve, moving from AS1 to AS2, which results in a new equilibrium at a higher price level (P2). As a result, the economy is now producing at a level lower than its potential GDP, with output falling from Q1 to Q2. This indicates that economic growth is being curbed, as firms are unable to maintain previous levels of production due to the higher costs of inputs like oil leads to a contraction in real GDP, and this decline in production and output slows economic growth, while rising prices further erode consumers' purchasing power. 

In response to these inflationary pressures, the Bank of England increases interest rates to reduce aggregate demand. Higher interest rates make borrowing more expensive for consumers and businesses, leading to a decline in consumption and investment. This results in a leftward shift of the aggregate demand curve from AD1 to AD2 on the second graph. The reduced demand now intersects aggregate supply at Q1, a lower level of output, while the price level remains at P2. Despite the reduction in demand, the price level does not immediately fall due to persistent inflationary pressures. This contraction in real GDP, from Q2 to Q1, shows that the increase in interest rates, while effective at controlling inflation, also suppresses economic growth. The economy is now producing below its potential output, represented by Q3, leading to slower growth and reduced output in the British economy.  

As inflation is curbed, the Bank of England decided to decrease interest rates back to pre-2022 rates, aiming to increase demand and mitigate the negative effects of cost-push inflation and the subsequent increase of interest rates on economic growth. Lowering interest rates makes borrowing cheaper, stimulating consumption and investment, which shifts aggregate demand from AD1 to AD3. This increase in demand alleviates some of the contraction in output caused by the higher costs, bringing real GDP back up from Q1 to Q4. While the price level remains elevated at P2, the real GDP improves, showing signs of economic recovery. Additionally, as businesses and industries begin to recover from the initial cost-push inflation, the long runaggregate supply curve (LRAS) shifts because of improvements in production capacity and efficiency. When the Bank of England lowers interest rates, borrowing costs decrease, which encourages firms to invest in capital, technology, and workforce development. These investments improve the economy's productive capacity over time, allowing firms to produce more goods and services at each price level. 

In conclusion, the Bank of England’s decision to cut interest rates from 5.25% to 5% marks a strategic shift from controlling inflation to revitalizing growth. While lower rates can stimulate spending, investment, and output, they also risk reigniting inflationary pressures if implemented too soon.