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Evaluate the likely effects on the economy of relying on higher interest

rates to reduce the rate of inflation


Interest rates are rates set by the central bank to the commercial banks to be
added to the cost of borrowing money or spending money.
One of the likely effects on the economy when higher interest rates occur is the
increase in the cost of borrowing. The interest payments and loans are more
expensive. This encourages people to save than borrowing. However, people who
have loans will have less disposable income because they have to spend more
portion of their income on interest payments. Higher interest rates also affect
those who have mortgage their assets. Those consumers with large mortgages
will be disproportionately affected by rising interest rates. Therefore, the rate of
consumption will fall.
Besides that, less firms will be attracted to invest into other fields and instead
they remain stationary. This discourages investors to invest on new projects in a
high-interest-rate country and would diverge to other countries with lower, yet
attractable interest rates. Nonetheless, this will only occur in the short run.
Since, investing in the short run is less beneficial, firms will save more, thus
placing their money in banks, hoping to get a higher return since higher interest
rates would interest ones money in the bank. In the long run, as the money put
in the bank grows, firms will use that money to invest in projects that it did not
have the opportunity to do so. Government spending would increase as the
money invested into the bank will be used to develop the sectors that needs to
be paid attention.
Other than that, higher interest rates also leads to less money circulated around
the economy. Low money circulation will cause an increase in the value of the
currency. Investors are more likely to save in ones countrys banks if the
countrys rates are higher than other countries. A stronger currency makes the
countrys exports less competitive. This causes a reduction in exports and
increasing number of imports instead. A shift to the left in the aggregate demand
of the economy also occurs.
This can be presented in a diagram below.
APL
SRA

Pe
P1

AD1
AD2
Y1 YFE

rGD

As interest rates increase, this causes the aggregate demand to shift to the left
from AD1 to AD2. The shift of aggregate demand causes the average price level
to decrease from Pe to P1 and eventually a reduction of output from YFE to Y1.
Such cases have led to a lower economic growth which eventually will lead to a
recession since less investments and consumption occurs in the economy.
Besides that, the fall of output shows the increase in unemployment. This is
because as output falls, firms will produce less goods and therefore will demand
less workers since less workers are needed to produce a small amount of goods.

In conclusion, a higher interest rates will lead to a falling in the whole economy
which defeats the purpose of helping the economy. Even though the increase of
interest rates will reduce the inflation rate, but the negative effects of interest
rates is beyond compared to the positive effects of the change. Nonetheless, of
the interest rates increase in a controlled state manner which means a slow
increase overtime, the negative effects of interest rates will not have much effect
then.