South-Western College Publishing - Economics  
Maybe It's Contagious?
Subject Interest Rates, Economic Growth
Topic International Finance
Monetary Policy
Key Words Interest Rates, Inflation, Economic Growth
News Story

A week after the Federal Reserve Bank raised U. S. interest rates, the European Central Bank, the Bank of England and South Korea all raised their interest rates. Further rate hikes, both in the U.S. and Europe, seem likely. These actions are the result of central banks becoming increasingly worried about inflationary pressures in their economies. The response of these central banks is to raise interest rates as a means to prevent inflation.

Economic growth in the United Kingdom is proceeding at a brisk pace. Unemployment is at 4 percent, its lowest level in 20 years and except for housing prices, which climbed 16 percent, inflation is below the Bank of England's target of 2.5 percent. Nevertheless, the Bank of England's Monetary Policy Committee raised interest rates by one-quarter percent, to 6 percent. Interest rates have increased a full percent since August.

Interest rates also increased in Korea, the first such increase in two years. The Korean economy grew by 10 percent last year and consumer prices rose just 1.6 percent. Even though there does not appear to be any signs of accelerating inflation, the central bank explained the rate hike as a move to narrow the differential between long- and short-term interest rates.

The European Central Bank (ECB) is worried about accelerating inflation. Consumer price increases were up 1.7 percent for the year ending in December and the ECB's goal is to keep the inflation rate under 2 percent. The weakness in the euro was also given as a reason for the one-quarter percent rate increase. The increased interest rates in the U.S. and U. K. threatened to weaken the euro still further. Analysts believe that the ECB's rate hike will encourage exports and strengthen the economy.

(Updated March 1, 2000)

Questions
1. In the U.S. and U.K., explanations for interest rate hikes focused on preventing inflation. How does an increase in the interest rate prevent inflation?
2. In Europe, justification for the interest rate hike centered on the impact of the U.S. and U.K. rates on weakening the euro. How is the exchange rate between the dollar and the euro affected by an increase in U.S. interest rates?
3. In South Korea, the explanation offered for the rate hike was to narrow the difference between short- and long-term interest rates. How are long- and short-term interest rates related? What role does inflationary expectations play in determining interest rates?
Source Silvia Ascarelli, Thomas Sims, Jane L. Lee and David Wessel, "Rates Climb as Global Economy Accelerates," The Wall Street Journal, February 11, 2000.

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