Monetary Policy - Deflation

If the Monetary Policy Committee consider that inflation is in danger of rising and perhaps going over their inflation target, then they may consider increasing interest rates. Increasing interest rates will discourage people (and firms) from borrowing money. It will also give people who have mortgages less money to spend each month as their mortgage payments rise. The combination of these effects will reduce the levels of consumption and investment. Since consumption and investment are two of the key components of aggregate demand, increasing interest rates should result in reduced economic growth and increased unemployment.

The government could also try to cut the level of money supply growth to cut inflation. Monetarists argue that this will happen as predicted by the Quantity Theory of Money.

Deflationary monetary policies are therefore:

• Increasing interest rates
• Reducing money supply

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 increasing interest rates. See what effect this has on economic growth and unemployment. Economic growth should end up lower than previously forecast, and unemployment higher. But what happens to inflation? What would you expect?

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