ChainWhat it assumes · how to break it
Start
The Monetary Policy Committee raises Bank Rate, for example from 4% to 5%.
1
As a result, commercial banks pass the rise on: interest rates on mortgages, loans and credit cards go up, and savings accounts pay more.
transmission mechanism
transmission mechanism
Assumes: Banks pass the rise on quickly and in full.
But: Most UK mortgages are fixed for two to five years, so a large part of the effect only arrives as those deals expire.
2
This means households with variable or expiring mortgages pay more each month, so discretionary income falls, and saving becomes more rewarding than spending. Consumption falls.
discretionary income
discretionary income
Assumes: Households are net borrowers.
But: Savers, often older households, receive more interest income and may spend more, which offsets some of the fall.
3
At the same time, borrowing to invest costs more, so fewer projects earn a return above the cost of the loan. Investment falls.
rate of return on capital
rate of return on capital
Assumes: Investment is sensitive to interest rates.
But: Investment depends more on expected demand and business confidence, and firms using retained profit do not need to borrow.
4
Since consumption and investment are components of aggregate demand, AD shifts to the left.
AD = C + I + G + (X − M)
AD = C + I + G + (X − M)
Assumes: Nothing else offsets the fall.
But: If government spending rises or export demand is strong at the same time, AD may barely move.
5
Therefore, with demand weaker relative to capacity, the positive output gap narrows and firms cannot raise prices as easily without losing sales.
demand-pull inflation · output gap
demand-pull inflation · output gap
Best link to attack
Assumes: The inflation is demand-pull.
Assumes: The inflation is demand-pull.
But: If the inflation is cost-push, for example from energy prices, a rate rise cuts output and jobs while doing little about the cause.
End
The rate of inflation falls back towards the 2% CPI target.
Time lag: the Bank of England reckons a change in Bank Rate takes up to about two years to have its full effect on inflation.
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Questions this answers
- Explain how an increase in Bank Rate might reduce inflation.
- Assess the effectiveness of interest rates in controlling inflation.
- Discuss whether monetary policy is the best way to reduce inflation.
Diagram
AD/AS: AD shifts left from AD1 to AD2; the price level falls from P1 to P2 (in practice, prices rise more slowly).
Reverse and related
Bank Rate cut → inflation rises. The same links run the other way, but a cut is weaker when confidence is low (‘pushing on a string’).