The Times is running a series of regular economic briefings to coincide with Target Two Point Zero, the Bank of England competition for sixth-formers run in conjunction with the paper. The challenge for students is to play the role of the Bank’s Monetary Policy Committee and choose the best level for interest rates. Today we explain the link between interest rates and inflation.

How do interest rates affect the level of inflation?
The rate of inflation, the pace at which consumer prices across the economy are increasing, is primarily determined by the overall balance of supply and demand in the economy. If total demand in the economy rises, this will tend to lead to an increase in inflation as more money chases fewer goods and services, bidding up the price. If demand falls, inflation will tend to drop back. Movements in interest rates work mainly by influencing the overall level of demand in the economy and so can have a powerful influence on the inflation rate.

The main policy tool of the Bank’s Monetary Policy Committee is the official short-term interest rate, known officially as Bank rate but often also referred to as the base rate.

Other things being equal, a rise in base rates will tend to dampen demand. A fall in rates will boost overall or aggregate demand, and so put upward pressure on the inflation rate. There are several ways in which interest-rate changes feed through into changes in inflation.

What is the link between interest-rate changes and the behaviour of consumers and businesses?
One of the most important ways that base-rate changes can affect consumer and business behaviour is through changes in borrowing costs. A rise in base rates from the Bank usually leads to an increase in the rates that commercial banks and other lenders charge customers (and vice versa).

When rates charged by banks rise, this makes it more costly for households and businesses to service their existing loans, as well as making it costlier to take on new debt. In turn, this reduces the money available to spend on other things, so reducing aggregate demand. Conversely, a cut in rates charged by commercial banks will boost the income available to consumers and businesses with existing debt, and make it cheaper to take on new debt. Other things being equal, this bolsters total demand.

What about the impact on confidence?
Changes in interest rates can have an important impact on business and consumer confidence. Usually, a rise in interest rates will deal a blow to confidence, for example, and that will make businesses and consumers less willing to spend, cutting demand.

How else can changes in rates of interest affect demand?
Movements in rates affect asset prices such as share and bond prices, with important knock-on consequences for demand, supply and the economy. Changes in official rates also have complex effects on the economy through the pound’s exchange rate. We will return to both of these topics in later briefings.

How long do interest-rate changes take to affect inflation?
Base rate moves can have some immediate effect on the economy through changes in business and consumer confidence. However, it can take a year for the full effect to be felt on demand and up to two years for a change to be fully reflected in the inflation rate. It is important to remember that these delays or lags are variable and uncertain.

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive