How do interest rates influence the rate of inflation
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Discuss the role of monetary policy in controlling inflation.
Monetary policy plays an important role in controlling inflation. The main tool of monetary policy, short-term interest rates, is manipulated with the specific aim of achieving an inflation target (of 2.5%). As shown in the chart below, interest rates are under constant review in order to try and keep inflation under control. For example, in the late 80s, interest rates went up to 15% because of excessive growth in the economy. The interest rate is therefore an important way in which monetary policy is used to control inflation.
A contraction in the real money supply is another way in which monetary policy can be used to control inflation. A contraction of the money supply has the effect of shifting the aggregate demand curve to the left, since there is less money available for consumers to spend. This is therefore a way of reducing demand-pull inflation. The opposite of this occurred in the late 1980s during the 'Lawson Boom'. There was a sharp rise in the demand for credit and an expl ...
