... capital unless they reduce their profit margins, which is unlikely, so investment would decrease. Monthly repayments on existing variable rate debt (especially mortgages) increase, leaving less disposable income for spending on goods and services. Aggregate demand will fall (AD1 to AD2) as a consequence, as consumption and investment are two of its components. Consequently there will be a fall in the price level (P to P1) meaning a reduction in inflation. However the rise in interest rates would increase hot money flows due to speculators wanting to take advantage of the increase in interest rates. This will strengthen the pound as more pounds are being demanded but the supply is not matched. This strengthening of the pound is likely to worsen the balance of payments because exports become more expensive and imports become cheaper. If the Marshall Lerner condition applies (sum of exports and imports is greater than 1) then the ...

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