How effective are interest rates in reducing inflation?

The main instrument of UK monetary policy is the use of interest rates, set by the MPC. The theory is that interest rates are very effective in controlling inflationary pressures. The relative success of meeting the government’s inflation target in the past 7 years suggests that this proves the effectiveness of monetary policy.
In brief raising interest rates helps to reduce Aggregate demand in the economy. When interest rates are raised several things are affected. Firstly those with mortgages have higher monthly payments, this reduces their disposable income and reduces their spending. Secondly there is an increased incentive to save money rather than spend. Thirdly those who have other forms of borrowing will be hit with increased interest repayments, it will also discourage people from buying on credit. Therefore in principal raising interest rates will reduce demand and prevent the economy from overheating. This enables inflationary pressures to be subdued.

However there are various factors which make interest rates less reliable as a means of monetary policy.

1. Firstly there is a long time lag before interest rates have an effect. People with loans will not stop their spending just because of interest rates rise. However in the future it may discourage people from borrowing and investing because of the higher interest rates. It is estimated interest rates can take 18 months to have a full effect. This is why Monetary policy is pre-emptive. The MPC try to predict inflation trends in the future and change interest rates before inflation increases.

2. Related to the last point is the difficulty of predicting future inflation trends. For example accurate information about the current state of the housing market is often difficult to obtain. If statistics about the current state of the housing market are difficult to obtain it shows how difficult it is to predict future statistics like house prices ( a cursory glance at predictions for house prices shows a wide range of forecasts)

3. Interest rates have different effects on different types of consumers. When interest rates rise, those with new large mortgages definitely feel a very painful financial squeezing. Even one quarter of a % can have a big impact on their monthly payments. However it is worth remembering that a large % of the population do not have very high mortgage payments. They have either paid off a large proportion of their mortgage or they are renting. Thus higher interest rates reduce the spending but only of a certain section of the population. Those with large savings may feel better off because they are getting higher interest payments each year.

4. It depends on consumer confidence. Higher interest rates may reduce people’s disposable income however if they are very confident about future income prospects they may not reduce there spending, confidence is a very important factor effecting consumer spending, it can have an unknown effect on UK monetary policy.

5. Higher interest rates have an effect on the £, increasing its value making it more difficult for exporters. Again this is often an unwanted side effect of monetary policy. Therefore monetary policy often has a more than proportionate effect on the manufacturing / export sector.


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