Economy Simplified: Monetary Policy and how it helps controlling Inflation.

Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
Inflation is indicative of the decrease in the purchasing power of a unit of a country’s currency.
Inflation occurs when spending on goods and services outstrips production.

Monetary Policy and Controlling Inflation: 

In a period of rapid economic growth, demand in the economy could be growing faster than its capacity to meet it. This leads to inflationary pressures as firms respond to shortages by putting up the price. We can term this demand-pull inflation.
In response to inflation, the Central bank could increase interest rates.
1. Higher interest rates make borrowing more expensive and saving more attractive.
2. Homeowners will have to pay increased mortgage payments, leading to less disposable income to spend.
3. Therefore households will have less ability and incentive to spend
4. Also firms will be deterred from borrowing to fund investment, leading to lower business investment.
Therefore, higher interest rates are quite effective in slowing down consumer spending and investment, leading to a lower rate of economic growth. And as economic growth slows down, so does inflation.

A higher interest rate should also lead to a higher exchange rate (higher interest rate attracts hot money flows) The appreciation in the exchange rate will also reduce inflationary pressure by:
1. Making imports cheaper. (There will be lower price of imported goods, such as petrol and raw materials)
2. Reducing demand for exports and therefore lower total demand in the economy.
3. Because exports are less competitive, exporting firms will have an incentive to cut costs and improve competitiveness over time.

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