Interest rates and inflation
Policymakers have two sets of tools to help them steer an economy in the direction they want. Monetary policy is used to combat inflation when it rises too fast or too high, and to stimulate the economy during recessions. Fiscal policy uses tax revenues to fund certain parts of the economy and to provide stimulus.
The primary tools of monetary policies are interest rates. Rapid price inflation is bad for an economy as some businesses cannot increase their prices as fast as their costs increase. Inflation also makes it difficult for businesses to plan, and so they put off new projects – when this happens across an economy, it slows, and investors become nervous.
If inflation gets out of control, the central bank can raise rates to slow borrowing and spending, which should slow inflation. In practice, it does this by raising the interest rate it charges commercial banks when they borrow from the central bank. This, in turn, causes banks to adjust the rates they charge their clients, and so interest rates throughout the economy rise.
If economic growth is too slow, or if inflation is low, central banks can lower interest rates. This incentivises businesses to borrow more, spend more and employ more people. When central banks adjust rates, they affect short term interest rates in the economy.