ECO16Interest Rates and Monetary Policy

• Interest rate: the cost of borrowing money and the reward for saving it, shown as a percentage a year.
• Borrowers pay interest to the lender (for example, on a loan, mortgage or credit card).
• Savers receive interest from the bank or building society that holds their money.
• Bank Rate (the Bank of England’s base rate) is the rate the Bank of England sets. It affects the rates that high street banks charge borrowers and pay savers. AQA’s vocabulary list calls it the base rate; exam papers often just say “interest rates”.
• When Bank Rate changes, other rates usually follow, though not always straight away or by the same amount.
• Principal: the amount saved or borrowed, before any interest.
• In November 2026, Bank Rate was 4% (decided on 5 November 2026). Last checked: 7 November 2026.

Interest rate

The cost of borrowing and the reward for saving, as a percentage a year.

Bank Rate

The interest rate set by the Bank of England that influences other interest rates in the economy (AQA calls it the base rate).

Principal

The amount saved or borrowed, before interest.

Bank Rate sets the general level, but banks charge and pay different rates on different products. Ask: how likely is the lender to get its money back?

• Savers and borrowers: banks pay savers less than they charge borrowers. The gap covers the bank’s costs and makes its profit.
• Amount borrowed: AQA’s teaching guide says larger loans often carry higher rates because more money is at risk. But large loans secured on a house (mortgages) usually have some of the lowest rates, so explain the risk in context.
• Savings: accounts where you lock money away for longer, or give notice before taking it out, usually pay more than easy-access accounts.

More risk for the lender means a higher rate of interest

Security (collateral)

An asset a borrower pledges, which the lender can claim if the loan isn’t repaid.

Secured loan

A loan backed by an asset, such as a mortgage on a house.

Unsecured loan

A loan with no asset behind it, such as a credit card balance.

Credit history

A record of how reliably someone has repaid past borrowing.

Mortgage

A long-term loan to buy property, secured on that property.

• Winners and losers: a rise helps savers with no debts and hurts borrowers, especially people with large mortgages. A fall does the opposite.
• Disposable income: income left after tax. Higher mortgage payments take a bigger slice of it.
• Confidence matters: a cut may not raise spending much if people are worried about their jobs or already have large debts.

Disposable income

Income left to spend or save after taxes.

Saving

Income that is not spent.

Variable-rate mortgage

A mortgage whose interest rate can change, often when Bank Rate changes.

• Costs: a rise makes existing variable-rate loans and overdrafts dearer, so profits fall.
• Investment: spending on machinery, buildings and technology is often paid for by borrowing. A rise makes it less worthwhile, so firms invest less.
• Sales: consumers spend less, especially on items bought on credit or that they can put off: cars, new homes, furniture, holidays and eating out.
• Exporters: higher UK rates can raise the value of the pound, which makes UK exports dearer abroad (see the Balance of Payments and Exchange Rates topic).
• Firms with cash in the bank earn more interest when rates rise.
• A fall does the reverse: cheaper loans, more investment and more sales.

Investment

Spending by firms on capital such as machinery, buildings and technology.

Overdraft

Borrowing by taking more out of a current account than is in it, up to an agreed limit.

• Interest for one year = amount saved × annual interest rate ÷ 100.
• For part of a year, multiply by the number of months ÷ 12.
• The question usually asks for the interest, not the total in the account. Don’t add the amount saved unless the question asks for the total.
• AQA has also accepted compound interest (interest earned on interest) where it applies, but simple interest is enough for part of a year.
• Real return: if inflation is higher than the interest rate, the savings buy less than before, even though interest was paid.

Simple interest

Interest paid only on the amount saved or borrowed.

Compound interest

Interest paid on the amount saved plus interest already added.

• Monetary policy: using interest rates (and other monetary tools) to influence the level of demand in the economy.
• Main tool: Bank Rate. Other rates follow it, so it changes borrowing, saving and spending.
• The money supply: the amount of money in the economy. More money and easier credit tend to raise spending (and can lower unemployment); less tends to reduce spending (and lower inflation).
• Who decides: the Bank of England’s Monetary Policy Committee (MPC) sets Bank Rate. The Bank has been operationally independent since 1997, so ministers don’t choose the rate.
• The target: the government sets the inflation target of 2% CPI, and the MPC sets Bank Rate to meet it. If inflation is more than 1 percentage point away from 2%, the Governor writes an open letter to the Chancellor to explain.
• Expansionary (loose) monetary policy: lower rates or more money. Contractionary (tight): higher rates or less money.
• AQA treats monetary policy as one of the government’s three policy types, with fiscal policy and supply-side policies. The Bank of England’s other jobs are in the Money and the Financial Sector topic.
• You may hear about quantitative easing (the Bank creating money to buy bonds). AQA doesn’t require it.

Monetary policy

Using interest rates and other monetary tools to influence the level of demand in the economy.

Monetary Policy Committee (MPC)

The Bank of England committee that sets Bank Rate.

Money supply

The total amount of money in the economy.

Inflation target

2% a year, measured by CPI, set by the government.

Controlling inflation is monetary policy’s main aim. Learn the chain, one step at a time.

• Step 1: the MPC raises Bank Rate, and high street banks raise their rates.
• Step 2: borrowing costs more and saving pays more, so consumers and firms spend less.
• Step 3: total demand in the economy falls (or grows more slowly).
• Step 4: firms find it harder to raise prices, so inflation falls (especially demand-pull inflation).
• The pound: higher rates can attract money from abroad, raising demand for the pound. A stronger pound makes imports cheaper, which also lowers inflation.
• Expectations: a rise shows the Bank means to hit its target, so firms and workers may expect lower inflation and ask for smaller price and pay rises.
• Time lags: many mortgages are fixed for years and firms’ plans take time to change, so the full effect can take a year or more.
• Cost-push inflation (for example, from higher world energy prices) is harder: higher rates can’t make oil cheaper, but they may stop price rises spreading into wages and other prices.

The chain from a rise in Bank Rate to lower inflation

Demand-pull inflation

Inflation caused by total spending growing faster than the economy’s output.

Cost-push inflation

Inflation caused by rising costs of production, such as wages, energy or raw materials.

Time lag

The delay between a policy change and its full effect.

• Conflict: raising rates to control inflation can slow growth and cost jobs. Cutting rates to boost growth can push inflation up. The MPC has to weigh these.
• Limits: banks may not pass on every change; people may not borrow if they lack confidence; when Bank Rate is already very low there is little room to cut it.
• Groups affected differently: borrowers and savers, firms that sell on credit, exporters and importers.

Expansionary monetary policy

Lower interest rates or more money, to boost spending.

Contractionary monetary policy

Higher interest rates or less money, to reduce spending and inflation.

Cyclical unemployment

Unemployment caused by too little demand, for example in a recession.

A dated example. Learn the method; use the numbers with their dates.

• August 2023: Bank Rate reached 5.25%, after rises to bring down high inflation.
• From 1 August 2024 the MPC cut Bank Rate in a series of steps, to 3.75% on 18 December 2025, as inflation came down.
• 5 November 2026: the MPC raised Bank Rate by 0.25 points to 4%. The Bank said energy prices had been pushed up by conflict in the Middle East, CPI inflation was 3.5% (September 2026) and was expected to reach about 5% by mid-2027, and the economy had been more resilient than expected.
• Views differ. Supporters of the rise argue it stops higher energy costs feeding into wages and other prices. Critics argue it squeezes households already paying more for energy, and that higher rates can’t lower world energy prices.
• The next decision was due on 17 December 2026. Last checked: 7 November 2026. Check the Bank of England’s website for the latest rate.

Bank Rate, August 2023 to December 2026 (simplified: the dashed line covers several cuts). Source: Bank of England