Inflation is a sustained increase in the general price level (and a fall in the real purchasing power of money). The rate of inflation is normally measured by a consumer price index, such as the Retail Price Index in the UK (which measures the annualised rate of change in prices over the preceding year). The Monetary Policy Committee of the Bank of England meets each month to set the official base rate of interest for the economy, with the aim of achieving an inflation target of 2.5% (+/- 1%) over a two year time horizon. Interest rates are currently used, therefore, as an important way of controlling inflation.
There are two main causes of inflation. The first is excessive growth in aggregate demand, leading to an inflationary gap (when the total demand for goods and services exceeds the total supply). This has the effect of shifting the aggregate demand curve to the right faster than the short-run aggregate supply curve.
The result is an increase in the price level (see diagram). This is demand-pull inflation and may be caused by a growth in the money supply, leading to 'too much money chasing too few goods'. It is this cause of inflation which interest rates tame in order to control the rate of growth of the price level.
Interest rates have a large impact on several components of aggregate demand. The transmission mechanism of monetary policy refers to the ways in which changes in interest rates affect the spending and saving decisions in the economy. Higher interest rates reduce aggregate demand in a number of ways (and therefore slow the rate at which the aggregate demand curve shifts to the right). Firstly, high rates discourage borrowing by both households and companies, which will reduce consumption (which is a component of aggregate...