Question

If the situation in an economy is that the current inflation rate is higher that the target inflation rate, does this mean the central bank (CB) should increase or decrease the interest rate?

Write a detailed description of how the the CB could make this choice, and additionally  describe the different steps that are required to change the interest rate.

Answer 1

Answer - If the current inflation rate is greater than the target inflation rate , the central bank will have to use the contractionary policies in order to bring the rate of inflation on target. For this , it will have to sell the government securities in open market , raise the reserve requirements and discount rate. Through these methods , the money supply will be reduce in the economy. Due to reduction in supply , there will be increase in the interest rates in the economy. Quantity of loanable funds will fall , demand will fall and hence inflation rate will drop.