Demand Theory of Microeconomics

Demonstration of a clear understanding of the issues. Use of academic models. Clear focussed understanding of a topic.

Critical analysis is an important test of the student’s ability to evaluate business economics concepts.

Introductions and conclusions should briefly address the issues to be discussed and discussed respectively.

The United Kingdom is a developed and sixth largest economy in the world with an annual growth rate of 1.9% in January 2016 and 2.10% in 2015. The service sector has the highest contribution to the GDP with 79%, Manufacturing sector contributes 10% and construction sector contributes 6% and agricultural sector contributes only 1%. For the last seven years, since 2009, the rate of interest is very low in Britain. It remains fixed at 0.50% monitored by Bank of England (BOE) which is the central bank for Great Britain (Card and Krueger 2015).

The paper discusses the affect of the low interest rate on the Britain economy over a period of seven years.  Several micro and macroeconomic indicators are explained in this respect and theories are used to argue the matter. The effect of low interest rate on consumption of an individual is shown through their change in the demand preference. In this respect demand theory of microeconomics is explained. On the other hand, the affect of the low interest rate on the market total saving and investment demand is shown by loanable fund theory of macroeconomics.

The demand theory of microeconomics explains the behavior of consumer demand towards the product available in the market. It relates the consumer demand with the factors affecting their demand. The factors are own product price, other product’s price, income, taste, preference of the consumer and other factors affecting demand. One of the other factors can be the change in the rate of interest in the economy (Rader 2014). If the rate of interest decreases then consumer saves less and consumes more of his total income, due to which his demand increases at the same market price. Thus shifting the demand curve to the right and creating excess demand in the market (Baumol and Blinder 2015).

According to the demand theory, the law of demand states that given all other factors affecting demand, there exist an inverse relation between the demand and price of the good, leading to a negatively sloped demand curve (Benigno et al.2015).

Figure 1: Downward sloping demand curve

Loanable Fund Theory of Macroeconomics

(Source: Created by the author)

Figure 1 shows the movement of demand due to the changes in its own price. When process decreases from P1 to P2, demand has increased from D1 to D2. The relation holds only when other factor affecting demand remains constant.  If one of the other factor affecting demand is the rate of interest of the country then as rate of interest decrease, people start saving less of their income and consume more of the income due to the fall in the return from saving.

As a result, at the same market price P1, consumer’s demand increases and the demand curve shifts to the right. If the supply of the product remains unchanged, then there is excess demand in the market which shoots the price up.

Figure 2: Rightward shift in the demand curve

(Source: created by the author)

Figure 2 shows the rightward shift of the demand curve due to the fall in the interest rate on savings, leading to creation of excess demand by the amount (D2-D1). If  A is the equilibrium point where the market demand and supply are equal to each other at price P1, then given the supply curve, at new equilibrium market price will rise to P2 and demand will fall to D3.

The seven years low interest rate by the Bank of England has also increased the consumer demand for different products. As a result, the total aggregate demand has shoot up and given the supply constraint, the British economy faces inflationary situation with continuous rise in price (Williamson and Wesley 2013).

Table 1: Inflation rate of United Kingdom from 2009-2016

(Source: Norton 2015)

Table 1 shows an upward trend of inflation from 2.2% in 2009 to 4.5% in 2011. It was due to the rise in aggregate demand may be resulting from fall in consumer saving as interest rate was reduced to 0.5% in 2009 from 5% in 2008. However after 2011, inflation rate has reduced to 2.8% in 2012 and then to 0% in 2015 and presently at 0.2% in 2016.

Loanable fund theory of macroeconomics illustrates the relation between the total demand for loanable fund and total supply of loanable fund in the economy. Loanable fund refers to the amount of money available for advancing loan in the economy (Nicholson 2014). The people who creates its demand are the investors those borrow money for business and production purpose and the people who save a portion of their income as saving, creates the supply of loanable fund in the economy. The total demand and supply of loanable fund determines the market equilibrium of interest rate (Mankiw 2014).

Conclusion

Figure 3: Demand and Supply of loanable fund

(Source: created by the author)

Figure 3 demonstrate the determination of market rate of interest (r) in loanable fund theory. The demand for loanable fund theory is downward sloping curve and is inversely related to r. The supply of loanable fund is upward sloping curve and is positively related to r. At the point where both curves meet (point A), market equilibrium rate of interest is reached where demand and supply of loanable fund are equal (Wickens 2012).

In the situation when reserve bank interferes and lower the rate of interest to achieve economic growth then there exist a disequilibrium situation in the economy. Suppose Bank of England reduces the rate of interest to r* in figure 3. Given the equilibrium state, there creates a shortage of loanable fund in the economy by the amount (L2-L1).  Under the situation, government needs to take steps to increase the loanable fund supply in the market to meet the excess demand for loanable fund by the business people (McCloskey 2015).

Bank of England has maintained a lower rate of interest since last seven years. The impact of this on the economy is reduction in the savings and increase in the demand for loan which has pushed the expenditures of the people (Smithin  2013). Further the demand for assets increases which raises the asset price and as the interest payments on mortgages have reduced, the people has more money to spend.  All the factors lead to increase in aggregate demand. The exchange rate of Britain tends to depreciate as foreigners willingness to save decreases which reduces the demand of pound in the foreign exchange market and led to the depreciation of pound (Jenkins et al. 2012).

United Kingdom government has taken several steps to control the inflation rate which has increased due to rise in demand. The money supply is controlled by BOE and taxes are imposed to combat disposable income of the consumer. Bank of England has taken precautionary steps to control the fall in the value of currency in the world market by intervening in the foreign exchange market (Salemi 2013). The prudent actions of BOE have helped to stabilize the value of pound in the global market and reduce the deficit in the current account of balance of payment. However, lower rate of interest have increase the economy production and output and enhanced the industrial growth rapidly which further reduce the unemployment rate and increased the per capita income of the people (Fernald 2014).

Conclusion

In conclusion, the brief of the paper is given. In the paper two theories are used to explain the impact of the low interest rate of British economy for last seven years. The demand theory of microeconomics is takes to explain the rise in demand of the consumer due to rise in consumption and fall in saving, a result of low interest rate. The loanable fund theory of macroeconomics is taken to explain the impact on investment and demand for loanable fund in the economy. Further, the monetary policy of BOE and fiscal policy has been discussed to control the impact of low interest rate on the economy. Bank of England(BOE) has intervened in the foreign exchange market to control the depreciation of currency and has been success in maintaining stable currency value.

Reference

Baumol, W. and Blinder, A., 2015. Microeconomics: Principles and policy. Cengage Learning.

Benigno, P., Ricci, L.A. and Surico, P., 2015. Unemployment and Productivity in the Long Run: The Role of Macroeconomic Volatility. Review of Economics and St

Card, D. and Krueger, A.B., 2015. Myth and measurement. Princeton University Pres.

Fernald, J., 2014. Productivity and Potential Output before, during, and after the Great Recession (No. w20248). National Bureau of Economic Research.

Jenkins, S.P., Brandolini, A., Micklewright, J. and Nolan, B. eds., 2012. The great recession and the distribution of household income. OUP Oxford.

Mankiw, N.G.R.E.G.O.R.Y., 2014. Principles of macroeconomics. Cengage Learning.

McCloskey, D.N. ed., 2015. Essays on a mature economy: Britain after 1840. Princeton University Press.

Nicholson, W. and Snyder, C., 2014. Intermediate microeconomics and its application. Nelson Education.

Norton, P., 2015. The British Polity. Routledge.

Rader, T., 2014. Theory of microeconomics. Academic Press.

Salemi, M.K., 2013. Intermediate Macroeconomic Theory. Applications of Mathematics in Economics, (82), p.27.

Smithin, J.N., 2013. Essays in the Fundamental Theory of Monetary Economics and Macroeconomics. World Scientific Publishing Company Pte. Limited.

Wickens, M., 2012. Macroeconomic theory: a dynamic general equilibrium approach. Princeton University Press.

Williamson, S.D. and Wesley, P.A., 2013. Macroeconomic Theory Economics 440.602. 81, Spring 2013. Economics, 440, p.81.