Interest Rates and Inflation - Chains of Reasoning

In this revision video we build two chains of reasoning explaining how a tightening of monetary policy can help to lower inflationary pressure.

Examiners are looking for clear chains of analytical reasoning for answers to get high marks. Build connective phrases into your answers. Good analysis then encourages stronger evaluation!

How higher interest rates can control inflation

Analytical chain 1

• If a central bank raises their main monetary policy interest rate
• This usually increases the costs of loans & also improves the incentive for people to save
• Consequently, this causes a slowdown in demand for new credit and mortgages and can lead to a rise in household saving
• As a result, weaker consumer spending helps to slow aggregate demand relative to potential output
• So, if the output gap becomes negative, then there is less demand-pull and cost-push inflationary pressure

Analytical chain 2

• A rise in base interest rates involves a tightening of monetary policy, otherwise known as a deflationary policy
• One possible consequence of this is an appreciation in the external value of a currency
• This is because higher interest rates attract savings deposits (hot money) from overseas in the banking system
• If the exchange rate appreciates, this will lead to a fall in the costs of imported products such as food and energy
• As a result, there will be an outward shift of short run aggregate supply and a fall in cost-push inflationary pressures.