... 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 demand). For example, higher interest rates may discourage people from buying items on hire purchase. Higher rates also encourage ...

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