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How do central banks use interest rates as a tool to control inflation, and what are the potential risks of using this monetary policy tool?
inflation Reserve bank of india uses monetory policy to manage economic fluctuations and achieve price stability, which means the price is low and stable.reserve bank of india conducts monetory policy by adjusting the supply of money, usually through buying or selling securities in the open market.Read more
inflation
Reserve bank of india uses monetory policy to manage economic fluctuations and achieve price stability, which means the price is low and stable.reserve bank of india conducts monetory policy by adjusting the supply of money, usually through buying or selling securities in the open market. Open market operation affects short-term interest rates, which in turn influence longer-term rates and economic activity. When central bank lower interest rates, monetory policy is easing.when it raises interest rates, monetory policy is tightning
how do central bank use interest rate as a tool to control inflationIn a period of rapid economic growth, demand in the economy could be growing faster than its capacity to meet it. This leads to inflationary pressures as firms respond to shortages by putting up the price. We can term this demand-pull inflation.
In response to inflation, the Central bank could increase interest rates.
1. Higher interest rates rates make borrowing more expensive and saving more attractive.
2. Homeowners will have to pay increase mortgage payments, leading to less disposable income to spend.
3. Therefore households will have less ability and incentive to spend
4. Also firms will be detered from borrowing to fund investment, leading to lower business investment.
5. Therefore, higher interest rates are quite effective in slowing down consumer spending and investment, leading to a lower rate of economic growth. And as economic growth slows down, so does inflation.
A higher interest rate should also lead to a higher exchange rate (higher interest rate attracts hot money flows) The appreciation in the exchange rate will also reduce inflationary pressure by:
• Making imports cheaper. (There will be lower price of imported goods, such as petrol and raw materials)
• Reducing demand for exports and therefore lower total demand in the economy.
• Because exports are less competitive, exporting firms will have an incentive to cut costs and improve competitiveness over time.
potential risk or disadvantages involved in using monetory policy
1. It does not guarantee economy recovery
See less2. It is not that useful during global recessions.
3. Its ability to cut interest rates is not a guarantee.
4. It can take time to be implemented.
5. It could discourage businesses to expand.