๐ Interest Rates as a Car Throttle: Imagine the economy is a car. The Bank of England sits in the passenger seat with a throttle. When the economy overheats (inflation rising), it pulls back โ raises rates. Borrowing gets expensive, spending falls, inflation cools. When the economy stalls (recession, deflation risk), it pushes forward โ cuts rates. Borrowing is cheap, spending rises, growth revives.
๐ Rate Rise Effects
Mortgages cost more โ households have less disposable income โ spending falls โ inflation falls โ currency tends to appreciate (hot money flows in).
๐ Rate Cut Effects
Borrowing cheapens โ consumption and investment rise โ AD shifts right โ growth stimulated โ may raise inflation โ currency may depreciate.
๐ป Quantitative Easing
When rates hit zero, the Bank creates money to buy bonds โ injecting liquidity directly. Used aggressively after 2008 and during COVID-19.
๐ฆ Inflation Targeting
Bank of England targets 2% CPI. If it misses by more than 1% either way, the Governor must write an open letter to the Chancellor explaining why.
Transmission Mechanism (how rate changes reach the economy):
Rate change โ Market interest rates โ Asset prices, exchange rates, expectations โ Consumer spending + Business investment โ Aggregate Demand โ Inflation
Rate change โ Market interest rates โ Asset prices, exchange rates, expectations โ Consumer spending + Business investment โ Aggregate Demand โ Inflation