How Do Interest Rates Influence Inflation?
How do interest rates influence the rate of inflation Inflation is a sustained increase in the general price level (and a fall in the real purchasing power of money). The rate of inflation is normally measured by a consumer price index, such as the Retail Price Index in the UK (which measures the annualised rate of change in prices over the preceding year). The Monetary Policy Committee of the Bank of England meets each month to set the official base rate of interest for the economy, with the aim of achieving an inflation target of 2.5% (+/- 1%) over a two year time horizon. Interest rates are currently used, therefore, as an important way of controlling inflation.There are two main causes of inflation. The first is excessive growth in aggregate demand, leading to an inflationary gap (when the total demand for goods and services exceeds the total supply). This has the effect of shifting the aggregate demand curve to the right faster than the short-run aggregate supply curve. The result is an increase in the price level (see diagram). This is demand-pull inflation and may be caused by a growth in the money supply, leading to 'too much money chasing too few goods'. It is this cause of inflation which interest rates tame in ord
This again will reduce the consumption element of aggregate demand. Fiscal policy is nevertheless often used in conjunction with monetary policy. Monetary policy plays an important role in controlling inflation. Lower interest rates might cause a depreciation of the exchange rate (due to speculative outflows of 'hot money' due to the relative increase in attractiveness of assets denominated in currencies other than sterling), thus raising the demand for exports. Firstly, high rates discourage borrowing by both households and companies, which will reduce consumption (which is a component of aggregate demand). The interest rate is therefore a useful way of controlling inflation. The first is that they are largely impractical since there is a time lag involved before a tax comes into effect. Since investment is a component of aggregate demand, aggregate demand will again fall due to a rise in interest rates. A contraction in the real money supply is another way in which monetary policy can be used to control inflation. Homeowners, for example, may take out housing equity loans (added to their existing mortgage) to finance big ticket spending. It is therefore very difficult for the government to be able to quickly implement a tax, for example, to reduce inflation. This has the effect of increasing the wealth of homeowners, making consumers feel more confident about their personal finances. Higher interest rates reduce aggregate demand in a number of ways (and therefore slow the rate at which the aggregate demand curve shifts to the right).
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