2.1.1a What an interest rate is

Interest rewards saving and is the cost of borrowing

1. A borrower pays interest on top of repaying the original sum, so borrowing has a cost.
2. A saver receives interest added to their money, so saving brings a reward.
3. The same interest rate can describe both sides, because a bank pays savers and charges borrowers.

Interest rates are shown as a percentage

1. An interest rate is quoted as a percentage of the amount borrowed or saved over a period, usually one year.
2. A rate of 4% per year means £4 of interest for every £100 held for one year.
3. To read a quoted rate, apply the percentage to the sum of money to find the interest in pounds.
4. The pound value of interest rises as the sum of money rises, even when the rate stays the same.

Risk, term, security and competition create different rates

1. Lenders charge more when the risk of not being repaid is higher, since a risky borrower is more likely to default.
2. A loan's term, the length of time before it is repaid, also affects the rate, since money is tied up for longer on some loans.
3. A secured loan, backed by an asset such as a house, usually carries a lower rate than an unsecured loan, because the lender can seize the asset if the borrower defaults. A mortgage from Nationwide, secured against a house, typically charges a lower rate than an unsecured personal loan from the same bank.
4. Competition between banks also matters, since more competition between lenders tends to push rates down, while less competition allows higher rates.
5. Savers usually earn a lower rate than borrowers pay, and this gap is how banks make their profit.

The Bank of England base rate guides other rates

1. The Bank of England base rate is set by the UK's central bank, and other interest rates tend to move up and down with it.
2. As of 30 August 2026, the Bank of England base rate is 3.75%, having been cut from 4.00% to 3.75% on 11 December 2025 and held at every meeting since.
3. When the base rate changes, banks tend to adjust the rates they charge borrowers and pay savers in the same direction.

2.1.1b Interest rates and consumer decisions

Higher interest rates encourage households to save more

1. When interest rates rise, saving earns a bigger reward, so households are encouraged to save more.
2. Money left in a savings account grows faster, making saving more attractive than spending today.
3. Some households cut back on current spending so they can put more money aside.

Higher rates discourage borrowing and spending

1. When rates rise, borrowing costs more, so households take out fewer loans.
2. Big purchases bought on credit, such as cars and furniture, become more expensive to finance.
3. Households that borrow less tend to spend less, so consumer spending falls.

Higher rates raise mortgage and loan repayments

1. Many households have a mortgage, a long-term loan used to buy a home.
2. On a variable-rate mortgage, a rise in interest rates raises the monthly repayment.
3. Higher repayments leave less disposable income for other spending.
4. Changes in the Bank of England base rate feed through to mortgage rates for millions of households.

Lower interest rates do the opposite and encourage spending

1. When rates fall, saving earns less, so households are less encouraged to save.
2. Borrowing becomes cheaper, so households take out more loans for big purchases.
3. Repayments fall on variable-rate mortgages, freeing up income to spend.
4. Lower rates therefore tend to raise consumer borrowing and spending across the economy.

2.1.1c Interest rates, producer decisions and calculations

Higher interest rates raise the cost of business borrowing

1. Firms often borrow to fund investment, meaning spending on capital such as machines and buildings.
2. When rates rise, the interest charged on a business loan rises, so borrowing costs more.
3. A higher cost of borrowing eats into the profit a firm expects from a project.
4. The Bank of England base rate guides the rates that banks charge firms, though risk, term, security and competition also affect the rate a firm is offered.

Higher interest rates discourage business investment

1. When borrowing is dearer, fewer investment projects are worth doing.
2. A project only goes ahead if its expected return is greater than the cost of borrowing.
3. Firms may delay or cancel plans to expand when rates are high.
4. Some firms save spare cash instead, because saving now earns a higher reward.

Simple interest on savings is calculated step by step

1. The formula for simple interest is the principal multiplied by the rate and by the number of years:

$$Simple\; interest=P\times R\times T$$

Lower interest rates encourage firms to invest

1. When rates fall, business loans become cheaper, so borrowing costs less.
2. More investment projects then have an expected return above the cost of borrowing.
3. Cheaper borrowing encourages firms to invest in new machines, buildings and jobs.
4. Lower rates therefore tend to raise investment across the economy.

2.1.2a UK government revenue and spending

Government spending runs services, builds assets and supports people

1. Government spending pays for public services such as healthcare, education, policing and defence, which markets may under-supply on their own.
2. It also builds and maintains infrastructure such as roads, railways and hospitals that households and firms rely on.
3. A further part supports people who are retired, on low incomes or unable to work.
4. Economists sort spending into three types: current spending, capital spending and transfer payments, covered in turn below.

Welfare and the NHS are the largest spending areas

1. The list below ranks the largest areas of UK government spending, largest first, using 2024 to 2025 outturn figures, the latest confirmed full-year totals.
2. Interest on the national debt appears in this list even though it buys no service directly. It is the price of borrowing in earlier years, so a bigger past deficit means more of today's spending is tied up before it reaches any service.

Current spending keeps public services running day to day

1. Wages and salaries: pay for doctors, nurses, teachers, police officers and soldiers.
2. Consumables: medicines, fuel, stationery and cleaning supplies that are used up soon after purchase.
3. Maintenance: repairs and upkeep of buildings and equipment that already exist.
4. Current spending does not create a new lasting asset, so its benefit is felt mainly within the year it is spent.

Capital spending builds assets that last for years

1. New infrastructure: motorways, railway lines, bridges and broadband networks.
2. New buildings: hospitals, schools and prisons.
3. Major equipment: scanners, military aircraft and large computer systems.
4. Capital spending adds to the country's stock of assets and can raise its future productive capacity.

Transfer payments move money from taxpayers to recipients

1. State pension: income for people who have retired.
2. Universal Credit and unemployment benefit: support for people out of work or on low incomes.
3. Child Benefit and disability benefits: help with the extra costs some families face.
4. Transfer payments redistribute income between people rather than paying for output, so they are counted separately from spending on services. The size and mix of spending matters because money used for one purpose cannot be used for another.

Governments raise revenue to pay for everything they do

1. Governments need revenue to pay for public services such as healthcare, education and defence, to build infrastructure, and to make transfer payments such as pensions and benefits.
2. In the 2024 to 2025 fiscal year, the UK government raised £1,148.7 billion in total revenue, equal to 40.8 per cent of national income, while it spent £1,276.2 billion, equal to 45.3 per cent of national income.
3. The gap between the two shows how much the government had to borrow that year:

Spending−Revenue=£1,276.2bn−£1,148.7bn=£127.5bn \text{Spending} - \text{Revenue} = \pounds1{,}276.2\text{bn} - \pounds1{,}148.7\text{bn} = \pounds127.5\text{bn} Spending−Revenue=£1,276.2bn−£1,148.7bn=£127.5bn

Spending outstripped revenue by around £127.5 billion in 2024 to 2025, the gap the government had to borrow to cover.

Taxation is by far the largest source of revenue

1. The two largest UK taxes, ranked by revenue raised in 2024 to 2025, were income tax and National Insurance combined, raising around £480 billion, and VAT, raising around £171.2 billion.
2. Corporation tax: charged on the profits companies make.
3. Council tax and business rates: charged on homes and business premises.
4. Fuel duty: charged on petrol and diesel sold at the pump.
5. These smaller taxes each raise less than income tax, National Insurance or VAT, though the exact 2024 to 2025 amount for each individually is not published as a single headline figure, so treat these as broad rankings rather than precise totals.

Borrowing covers spending that taxes do not

1. When planned spending is greater than the revenue raised from taxes and other income, the government borrows to make up the difference, as it did with the roughly £127.5 billion gap in 2024 to 2025.
2. Investors who buy government bonds lend the money in return for interest, so borrowed money has to be repaid later rather than being a permanent source of income.

Other income adds smaller amounts on top

1. Fees and charges: payments for things like passports, prescriptions and court services.
2. Profits and dividends: income from organisations the government owns or has a share in.
3. Sales and fines: money from selling assets and from penalties such as speeding fines.
4. Taxation remains by far the largest source of government revenue, with borrowing and other income making up the rest.

2.1.2b Direct, indirect and progressive taxation

Taxes are classified in two separate ways

1. The first classification asks what a tax is charged on, dividing taxes into direct and indirect.
2. The second classification asks how the share of income taken changes as income rises, dividing taxes into progressive, regressive and proportional.
3. The two classifications are separate, so any tax can be described using both at the same time, for example as direct and progressive.

Direct taxes are charged on income and profits

1. Income tax is charged on the money people earn from work, and National Insurance is charged on earnings too, both deducted straight from wages.
2. Corporation tax is charged on the profits that companies make, and is paid directly by the firm.

Indirect taxes are charged on spending

1. VAT is charged on most goods and services at the point of sale.
2. Fuel duty is charged on the petrol and diesel sold at the pump, on top of VAT.

Progressive taxes take a bigger share as income rises

1. UK income tax is progressive because it is charged in rising bands (2026/27 tax year): no tax on the first £12,570 earned, then 20 per cent up to £50,270, then 40 per cent up to £125,140, then 45 per cent above that.
2. Because more of a higher earner's income falls into the higher bands, they pay a bigger percentage of their total income in tax, not just a bigger amount.

Regressive and proportional taxes behave differently

1. A flat-rate indirect tax such as VAT is regressive when measured against income, because a poorer household typically spends a larger share of its income than a richer one, so VAT eats up a bigger percentage of a low income than a high one.

A worked example shows why VAT is regressive

1. Comparing two households that spend the same amount shows how a flat-rate tax like VAT ends up taking a bigger share of a lower income.

Every tax gets one label from each scale

1. Income tax is a direct and progressive tax, since it is charged on earnings and takes a rising percentage as income grows.
2. VAT is an indirect and regressive tax, since it is charged on spending and takes a bigger share of a poorer household's income.
3. When classifying a tax in an exam, always give both labels to show you understand that the two scales are separate.