Interest Rate Theories - Monetary Policy - How is the interest rate used?

The only chance that the government has to alter the stance of its fiscal policy is once a year in the Budget. This can tend to make fiscal policy a fairly blunt instrument of economic management. Monetary policy and the alteration of interest rates are therefore important weapons in the government's economic armoury.

Interest rates are set by the Bank of England's Monetary Policy Committee. They will set the rate according to the prevailing economic conditions and the inflation target they have been set. If they feel that there are significant inflationary pressures in the economy, then they will tend to increase the level of interest rates. This will tend to discourage borrowing and therefore reduce aggregate demand. The effect of this is shown in the diagram below as a shift from AD3 to AD2:

As a result of the level of borrowing and therefore aggregate demand falling the inflationary pressures in the economy have been reduced. These inflationary pressures may have come from excessive growth in wages, excessive growth in lending by financial institutions or perhaps over-optimistic expectations in the economy.