Economics – Government and the macroeconomy - Monetary policy | e-Consult

The Bank of England (BoE) uses interest rates as a primary tool of monetary policy to influence inflation and economic growth. Higher interest rates are typically used to combat inflation, while lower interest rates are used to stimulate economic growth.

Controlling Inflation: When inflation is high, the BoE increases the bank rate (the official interest rate). This has several effects:

• Increased Borrowing Costs: Higher interest rates make it more expensive for businesses and consumers to borrow money.
• Reduced Spending: Increased borrowing costs lead to reduced spending on things like houses, cars, and investments.
• Increased Saving: Higher interest rates make saving more attractive, leading to a decrease in spending.
• Reduced Demand: The combined effect of reduced spending and increased saving leads to a decrease in aggregate demand.
• Lower Inflation: With lower aggregate demand, businesses are less able to raise prices, thus curbing inflation.

Promoting Economic Growth: When economic growth is sluggish, the BoE lowers the bank rate. This encourages borrowing and spending:

• Decreased Borrowing Costs: Lower interest rates make it cheaper for businesses and consumers to borrow.
• Increased Spending: Lower borrowing costs encourage spending on things like houses, cars, and investments.
• Reduced Saving: Lower interest rates make saving less attractive, leading to an increase in spending.
• Increased Demand: The combined effect of increased spending leads to an increase in aggregate demand.
• Higher Economic Growth: With higher aggregate demand, businesses are incentivised to invest and expand, leading to economic growth.

However, there are potential drawbacks. Lower interest rates can lead to asset bubbles (e.g., in the housing market) and excessive risk-taking. Higher interest rates can slow down economic growth and potentially lead to a recession.