UK interest rates and economic growth

Why have constant low interest rates not had the desired effect of increasing GDP like economic theory would dictate?

Interest rates have been at a record low of 0.5% for more than three years now an outcome the monetary policy committee had in mind was an increase in GDP. This increase in GDP would stem from the theory that comparatively low interest rates should increase consumer spending and also investment. These increases contribute to an overall increase in demand in the economy, which in an ideal world would lead to no/minimum inflation while decreasing unemployment as supply tries to keep up with demand.


The increase in consumer spending and investment comes from the idea that such a low interest rate gives people and firms’ very little incentive to save, so therefore spend more. The interest rate means that consumers get very little interest on their savings in banks and it also means for firms that it is 'cheaper' to borrow money from banks to finance ventures such as buying new machinery as they pay less interest on their loans.


This seems like justifiable plan, but the theory is under the constraints of ceteris paribus, meaning that it will work with all other things staying equal, so no other interferences on the economy. This highlights a limitation that can be seen in many economic theories and is the reason why economists cannot predict the future of an economy, which does not live up to the expectation of many people.

The interference that is stopping this seemingly painless answer to our problems are the fiscal policies also being undertaken. The restrictive fiscal policies are a way of reducing the national deficit (not national debt as the media often publicises). The government are rightly trying to reduce this deficit to a reasonable level, which allows the national debt to become manageable.

Austerity reduces government spending in the economy, which directly reduces the demand in an economy. It also leads to a potential reduction in consumer spending as benefits or public sector wages are reduced. This reduction in demand and other factors such as low confidence counteract the increase in demand that should be seen due to the low interest rates. In addition since interest rates are low but have not really increased demand in the economy to a sufficient level, they will have to stay at this record low for the foreseeable future, while different monetary devices are used such as quantitative easing.