Between February 2022 and February 2023 the central bank of South Korea increased the base rate of interest from $$\(1.25 \%\)$$ to $$\(3.5 \%\)$$. Evaluate the likely macroeconomic effects of an increase in interest rates on a country of your choice.

Indicative content guidance
Answers must be credited by using the level descriptors (below) in line with the general marking guidance.
The indicative content below exemplifies some of the points that candidates may make, but this does not imply that any of these must be included. Other relevant points must also be credited.

Quantitative Skill Assessed
QS9: Interpret, apply and analyse information in written, graphical, tabular and numerical forms

Knowledge, Application and Analysis (12 marks) - indicative content
- Definition/understanding of interest rate
- Identification that interest rates are a monetary policy instrument
- Deflationary policy
Effects include:
- Decrease in consumption (C) as it creates a disincentive to spend; also consumption decreases as cost of borrowing rises and there is a greater incentive to save in South Korea as the return on saving increases
- Create negative wealth effects: higher interest rates will raise the cost of borrowing, so individuals will be less likely to borrow to purchase houses this will contribute to a decrease in house prices, reducing confidence and consumption in South Korea
- Reduces spending as consumers with variable rate loans/mortgages see interest repayments increase, decreasing discretionary incomes
- Decrease in investment (I), as the cost of borrowing to finance investment rises increasing firms' cost of production in South Korea
- Decrease in the net trade balance (X-M) as it will put an upward pressure on the exchange rate, meaning imports become relatively cheaper (greater demand), and exports become relatively expensive (lower demand)
- AD shifts inwards leading to (may be shown diagrammatically):
\(\bigcirc\) fall in South Korea's economic growth as real output falls
\(\bigcirc\) lower demand-pull inflationary pressure as price level falls
\(\bigcirc\) rise in unemployment as lower real output means less workers are likely to be employed in South Korea
\(\bigcirc\) negative multiplier effects: further reduction in real output
NB Award a maximum of Level 3 for answers with no reference to a country in their answer
Evaluation (8 marks) - indicative content
- Significance of the size of the increase in the base rate of interest: 2.25 pp is a relatively large increase in one year and may have the desired impact on the economy of South Korea
- Changes in the interest rate usually have an 18 to 24 month time lag before their full effects are filtered through South Korea's economy
- Consumption and investment may not fall if both consumer and business confidence is relatively high in South Korea
- Commercial banks in South Korea may not pass the higher rates to firms or consumers, thereby less likely to reduce consumption and investment
- Impact on real output will depend on the size and value of the multiplier
- Impact on real output/inflation depends on the elasticity of the LRAS and the level of spare capacity in South Korea's economy
- It is unlikely that changes in the interest rate by the central bank will be able to control cost-push inflation e.g. caused by rising energy prices
- Impact may be limited if the central banks of other countries have also increased their base interest rates