Why do the government use interest rates to control inflation?
The monetary approach to inflation-control is based on the theory that inflation is caused by an excess of purchasing power. In a quick phrase: too much money chasing too few goods and services. The Bank of England responds to the Monetary Policy Committee by expanding or contracting the supply of money and therefore affecting interest rates. The mechanism for this is quite complicated, involving the issue of government stock and the rates at which the B of E will lend to various borrowers. Also, the Bank is empowered to control the credit creation process through liquidity ratio requirements in the banking sector. The theory is that a rise in interest rates, and the corresponding limitation in money supply, will “damp down” excess demand and “take the pressure out of market”. The intention is to reduce households’ and firms’ willingness to buy goods and services through making credit more expensive. There is something fundamentally unsatisfactory about this process and the theory behi
