What effect does changing the UK bank rate have on inflation, AND WHY?
Question by Philosophical Fred: What effect does changing the UK bank rate have on inflation, AND WHY?
Conventional, and generally accepted wisdom is that increasing interest rates cuts the supply of money and therefore reduces inflation.
But:-
1. If the price of money goes up, why don’t suppliers of goods and services INCREASE their prices to compensate for the increased cost of their capital, hence INCREASING inflation?
2. Inflation rates themselves only affect the cost of money. Prices depend upon the decision-making processes of actors in the economic market. To understand the effect of interest rates on inflation you need an explanation of how individuals think in realtion to such policy decisions.
3. In the UK today, inflation rates vary hugely between different sectors of the economy e.g. prices of goods as opposed to house prices. How can you control such complex phenomena by adjusting a global interest rate?
Economists historically got it spectularly wrong in relation to exports (C18 mercantilism). and to balanced budgets in early C20. Have they got it wrong again?
Best answer:
Answer by trolling_for_fundies
1) and 2) you are confusing yourself with the pricing questions – in 1) you assume a magical, united group of suppliers, whereas in two you correctly point out the micro/decision making aspect.
To generally answer your question, when interest rates rise consumers are less willing to spend money and more apt to save; which means that suppliers CAN’T raise their prices because no one would buy their products.
In a healthy economy, inflation is normally caused by strong economic growth. This growth is curbed by reducing incentives for consumption and investment.
Edit: To add to your list at the end, economists/policy advisors were also wrong about the Phillips curve.
What do you think? Answer below!
