Why do the government use interest rates to control inflation?

Question

Like the Bank of England running the show makes any difference! OK, allow me to rephrase, substitute BofE for government.

Answer 1

It is the easiest way a Govt. can control an economy. If they need to decrease inflation they can increase interest rates to slow the rate of borrowing. If people can not borrow they can not build or buy really expensive stuff. This slows the economy in turn slowing inflation. THe opposite is true as well. If the economy is not moving along at a quick enough pace, the Govt can decrease interest rates making it easier to borrow.

Answer 2

brown passed on responsibility of interest rates to the bank of england in 1997, (thank god!)

Answer 3

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 behind it.  In the current inflationary situation, price increases were initiated by external factors such as petroleum supply and the failure of banks in USA.  Therefore, inflation in UK is not caused by excess demand but by increased input costs.  Therefore, monetary policy alone cannot be expected to control the economy.  In fact, a rise in interest rates adds to inflation through raising the costs of manufacture, housing, transport and vehicles and so on.

By "standard" economic theory, inflation ought to correspond to labour shortages, excess demand for manufacturing output, congestion in financial markets with shortage of credit for large numbers of borrowers, and so on.  Deflation, on the other hand, should correspond to the opposites of these.  Currently, in UK and USA, there is price inflation but all the other indicators suggest deflation, recession, maybe the start of an economic depression.  Simple monetary policy has no answer to these conflicting indicators.

There are other mechanisms available to governments to control total demand for goods and services including tax changes and rationing.  Since the days of Margaret Thatcher, who espoused monetary economics whole-heartedly, these other approaches have not been used in UK or USA.

Answer 4

It is the easiest and cost-efficient way of controlling inflation without any side-effect. The alternative method would be price control, but price control is subject to illegal trading and it can create inefficiency.

Interest rate is used instead to let the market correct itself, through fine-tuning it. The other advantgae of using interest rate would be its direct effect on inflation.

Answer 5

They don't control interest rates. They control the supply of money. It is the supply and demand for the money that sets the interest rate.