Development of an individual economy passes through different economic phases. Sometimes it is booming and sometimes it suffers from recession. This phenomenon can be viewed as projection of consumption and investment strategies of the individuals and the government of the country. Interest rate, being a major factor of economics, plays a great role in economic activities carried out by nation and the nationalities. A change in interest rates may affect other factors of the economy. For instance, investment strategies of the investors, consumption strategies of the individuals, foreign exchange, imports, exports etc. are affected by the interest rates. An increase in interest rates may decrease the investment, decrease the consumption, and affect the exchange rates and finally may influence the GDP of the nation. However, the effect of the interest rate on consumption behaviour has been a subject to controversy.
Gross domestic product (GDP), measure of development of the economy, is composed of different factors of the economy such as consumption, investment, government expenditure, import and export. GDP is often correlated with the standard of living. Among these factors, normally consumption occupies a largest chunk. So a change in consumption directly affects the GDP. So, the interest rates, consumption and the GDP are interrelated. Thus, I intend to demonstrate the correlation between ‘interest rates and consumption’ and ‘interest rates and GDP’ of the United Kingdom, in short run, through this dissertation.
Many economists have put forward their findings about the relationship between interest rate and consumption. But, the effect caused by the interest rate on consumption strategies has been a matter of controversy. Before Keynes (1936), many economists considered the interest to be the important factor to determine the propensity of saving. Keynes introduced ‘Absolute Income Hypothesis’ (AIH) in 1936 which demonstrated that fluctuations in the short run interest rate had no significant effect on spending decisions; rather the consumption behaviour is entirely dependent on current income.
The theory asserts that as income rises, the consumption will also rise. However, the increase in consumption may not necessarily follow the same rate of increase in income. Kuznets (1946) reported that the saving rate was not a function of current income. Since the saving ratio remained stable over long range of time. Unlike Keynes, in Modigliani’s (1953) ‘Life Cycle Hypothesis’ (LCH), he assumes that the interest rate plays an influential role in consumption behaviour. According to LCH that individuals consume a constant fraction of the present value of their life time income.
The life-cycle model also predicts that individuals save some fraction of their income, while they work, in order to finance their consumption after they retire. In 1957, an American economist Milton Friedman developed a theory called ‘Permanent Income Hypothesis’ (PIH). This theory explains the consumption pattern of individuals. According to this theory “the choices made by the individuals regarding consumption and saving behaviour are determined not by current income but by their longer-term income expectations”.
Individuals spend more today when they expectation to earn more in future for a longer time. This means individuals’ consumption pattern is determined by their permanent income not by their current income and the permanent income is determined by the permanent asset. Robert Hall (1978), ‘Random walk model of consumption’ explains that the consumption is unpredictable since it only changes when there is surprising news about the income. GDP, an indicator of prosperity of the economy, is also determined by the imports and exports.
Imports and exports are influenced by the exchange rates and the interest rate causes fluctuation in the exchange rates. When the exchange rate appreciates or depreciates, the relative prices of imports and exports change; biz/ed (n. d. ). This means interest rate has a significant influence in the imports and exports. Methodology: There are several factors that limit for the exhaustive data collection as required for the quantitative analysis. However, this research will be based on the analysis of secondary data on the basis of relevant theoretical support.
In this respect the aim of the dissertation will be addressed through desk research. The desk research will begin with text books related to the macroeconomics and financial management and the statistics to identify the related theories. In addition, articles in journals, related news papers will be referred for the currents updates. For the study of the books and journals; college library, some local libraries, online library of University of Wales and the British library will be used. And I have access to all these above mentioned libraries.
The results from the desk research will be used to formulate the data analysis strategy, find the inductive approach to research. Since this is a secondary research, all the data that are required for the analysis will be accessed from the website of Bank of England and the UK National Statistics. The information about the interest rates and exchange rates will be accessed from the official website of Bank of England. The information about the consumption, investment, government expenditure, imports and exports will be obtained from the official website of UK National Statistics.
Work Plan: The whole dissertation will be divided in manageable pieces of work as shown in the Gant Chart in the appendix A. Conclusion: Gross Domestic Product (GDP) is an indicator of prosperity of an economy. GDP composed of five factors of the economy, namely, consumption, investment, government expenditure, imports and exports. Among these factors consumption occupies a large proportion of GDP. Interest rates being a key to influence the economic activities, it is used as a tool to control the unwanted deviations of the nation’s economic activities.
Normally, central bank of the nation bring changes in interest rates to keep track the nation’s economic and financial performance. The pattern of Consumption has been a subject to controversy. There are lots of theories about the consumption function. Firstly, this dissertation will try to test the theories, in short run, using the deductive approach and secondly, it will find a regression equation defining the relation between interest rates and consumption.