The monetary policy committee uses the CPI to examine whether to increase, decrease or to keep on hold the interest rate to attain the inflation target. This policy is known as the monetary policy and is a demand side policy. An increase in interest rates will affect components of aggregate demand, particularly consumption. High interest rates will encourage savings and discourage spending, resulting in lower consumption and a fall in aggregate demand. Consumption may also be affected as higher interest rates mean higher mortgage payments; this will lead to a fall in disposable income and a reduction in consumption. This effect will be more pronounced by the multiplier, as savings is a withdrawal from the circular flow of income and the fall in AD will be in greater proportion compared to the size of the withdrawal. As shown in the diagram (AD diagram drawn, show shift in AD to the left, fall in price and output), the price has fallen from P to P1, and real output has relatively decreased from O to O1. P
The multiplier will depend on the marginal propensity to save and consume. If MPC is high, consumers may still spend in spite of the increase in interest rates. The fall in price and output level will ultimately depend on the position of AD. In addition, it will also depend on the magnitude of the rise in interest rates, as 0.01% increase in interest rates will be unlikely to make a big impact on the spending and saving pattern of the economy. An increase in interest rates will also attract the flow of hot money into the economy. Foreigners will be encouraged to save in UK bank accounts as they will benefit more from the high interest rates. This will result in higher demand for the English pound and then pushing up the price of the pound. Consequently, this will lead to a rise in exchange rates. A rise in exchange rates will make exports more...