How does a central bank control inflation?

A central bank controls inflation through monetary policy. In the Cambridge AS and A Level syllabus, the tools of monetary policy are interest rates, the money supply and credit regulations. Let's start with interest rates.

Here are the steps from a rate rise to lower inflation. When the central bank raises its rate, banks raise the rates they charge on loans and pay on savings. Borrowing costs more, so households buy fewer things on credit, such as cars and homes. Some people have loans where the interest rate can change. They now pay more interest and have less left to spend. Savings earn more, which makes some people save more and spend less. Firms also borrow less to invest in machines and buildings.

Together, these changes lower total spending in the economy. With weaker demand, firms find it harder to raise prices, so inflation slows down. There's an exchange rate effect as well. Higher interest rates can attract savings from abroad, which raises demand for the currency. The currency rises in value (appreciates), so imports become cheaper and prices at home rise more slowly.

The other two tools work in a similar way. If the central bank slows the growth of the money supply, there is less money available to spend. Credit regulations, such as limits on how much banks can lend, make loans harder to get. Both reduce spending, which helps to slow down price rises.

One major weakness is the time lag. A change in interest rates takes many months to have its full effect on prices. By then the economy may have changed. The rate rise could slow down an economy that is already getting weaker. Higher rates can also cut investment and raise unemployment. If the inflation is cost-push, lower spending does little about the cause. Use these points for evaluation in an answer on monetary policy. At A Level, the Phillips curve gives you another way to discuss the link between inflation and unemployment.