Monetary Policy - Reflation

If the Monetary Policy Committee consider that inflation is falling and they will easily meet their inflation target, then they may consider cutting interest rates. If there is a danger of the economy suffering a downturn this will help reinforce this decision. Cutting interest rates will encourage people (and firms) to borrow more money. It will also give people who have mortgages more money to spend each month as their mortgage payments fall. The combination of these effects will increase the levels of consumption and investment. Since consumption and investment are two of the key components of aggregate demand, cutting interest rates should result in increased economic growth and reduced unemployment.

The government could also allow the money supply to increase to encourage spending, but monetarists argue that if this is allowed to happen too much inflation will result. This is predicted by the Quantity Theory of Money.

Reflationary monetary policies are therefore:

• Cutting interest rates
• Allowing money supply to increase

Why not try this on the Virtual Economy? Click on the 4th floor or on The 'Model' in the top navigation bar to get to the model. You do not have control over the money supply in the Virtual Economy, but you can try cutting interest rates. See what effect this has on economic growth and unemployment. Economic growth should end up higher than previously forecast, and unemployment lower. But what happens to inflation? What would you expect?

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