Inflation is a sustained increase in the general price level (and a fall in the real purchasing power of money). The rate of inflation is normally measured by a consumer price index, such as the Retail Price Index in the UK (which measures the annualised rate of change in prices over the preceding year). The Monetary Policy Committee of the Bank of England meets each month to set the official base rate of interest for the economy, with the aim of achieving an inflation target of 2.5% (+/- 1%) over a two year time horizon. Interest rates are currently used, therefore, as an important way of controlling inflation.

There are two main causes of inflation. The first is excessive growth in aggregate demand, leading to an inflationary gap (when the total demand for goods and services exceeds the total supply). This has the effect of shifting the aggregate demand curve to the right faster than the short-run aggregate supply curve. The result is an increase in the price level (see diagram). This is demand-pull inflation and may be caused by a growth in the money supply, leading to 'too much money chasing too few goods'. It is this cause of inflation which interest rates tame in ord

Lower interest rates, on the other hand, stimulate demand in the housing market, causing an upward pressure on house prices. This has the effect of increasing the wealth of homeowners, making consumers feel more confident about their personal finances. Homeowners, for example, may take out housing equity loans (added to their existing mortgage) to finance big ticket spending. Such behaviour will lead to an increase in consumer spending and therefore aggregate demand, possibly leading to demand-pull inflation. This is therefore another way in which interest rates influence inflation.

Discuss the role of monetary policy in controlling inflation.

Fiscal policy is nevertheless often used in conjunction with monetary policy. For example, during periods of inflationary pressure, interest rates may be increased and increases in government spending may be frozen. Such policies then complement one another and drastic fiscal measures are not needed. In addition, during periods of economic growth and inflationary pressures, tax revenues automatically increase (through increases in employment) and government spending is reduced (due to fewer transfer payments). Fiscal policy, therefore, automatically helps to reduce inflation. Despite this, however, the automatic stabiliser on its own is not enough to keep inflation at bay and monetary policy remains central to the control of inflation.

er to control the rate of growth of the price level.

Interest rates therefore have a big impact on the rate of inflation. An increase in interest rates results in a decrease in aggregate demand (although by how much partly depends upon the interest elasticity of demand for bank loans). Since excessive growth in aggregate demand is one of the main causes of inflation, interest rates and inflation are related. The interest rate is therefore a useful way of controlling inflation.

Lower interest rates might cause a depreciation of the exchange rate (due to speculative outflows of 'hot money'

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