Discuss the Effectiveness of Using Interest Rates to Control the Rate of Inflation (Diagrams Must Be Inserted by Hand)

Topics: Inflation, Aggregate demand, Monetary policy Pages: 3 (1094 words) Published: April 21, 2013
Discuss the effectiveness of using interest rates to control the rate of inflation. In 1997 the Bank of England was given independence over monetary policy in the UK. It was given the role of setting interest rates on a monthly basis for the purpose of achieving an inflation target of 2% (+/-1%) as measured by the CPI.

The diagram above shows a short run aggregate supply curve and how an increase in interest rates may affect it. If the change is successful consumption, investment, and exports will decrease and imports will increase. This will result in the AD curve shifting left and a contraction of the equilibrium point along the SRAS curve concluding with a decrease in General Price Level and Real GDP. The decrease in the rate of inflation is shown as P to P1 and the decrease in RGDP is shown in Y to Y1. Increasing interest rates is used to control the rate of inflation due to the effects that it has on various proponents of aggregate demand. One of these is consumption, and plays a large role in lowering AD. Firstly, there will be a greater incentive to save as the return is greater and therefore people will be spending less of their money on consumer goods and services in order to maximise money saved. Existing loans (for example mortgages) will become more expensive because payments will increase, meaning that households will have less discretionary income. However this only affects those with a mortgage that is not fixed, meaning that if fixed mortgages are very popular then the effects might be less obvious. New loans will become more expensive too, meaning households will find buying big tickets items such as cars, furniture and appliances far less affordable. Unfortunately for people who invest their money in financial assets, these assets will fall in value (for example houses, shares, and bonds). This is due to a decrease in demand for such products, and less wealth equals less consumption. It is not only the consumer that is hit by increases in...
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