The Times is running a series of regular fortnightly economic briefings to coincide with Target Two Point Zero, the Bank of England's contest for sixth-formers run in conjunction with the paper. The competitions challenge students to play the role of the Bank's Monetary Policy Committee and choose the best level for interest rates.

This week: 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 increases, is mainly determined by the overall balance between the supply of goods and services in the economy, and demand for these. Other things being equal, if total demand 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, then inflation will tend to fall. Movements in interest rates work mainly by influencing the level of demand and so can have a powerful influence on the inflation rate.

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

A rise in base rates will tend to dampen demand. A fall will boost “aggregate” demand and 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?

A rise in base rates 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 meet payments on 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?

Usually, a rise in interest rates will deal a blow to confidence, making 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 prices, with important knock-on consequences for demand and supply. Changes in rates also have complex effects on the economy through the pound's exchange rate. We will return to both of these topics.

How long do interest-rate changes take to affect inflation?

Rate moves have some immediate effect through confidence. However, it can take a year for the full effect to feed through to demand, and up to two years for a change to be fully reflected in inflation. These delays or “lags” are variable and uncertain.

www.timesonline.co.uk/targettwopointzero

www.bankofengland.co.uk/education/targettwopointzero

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