The main instrument of UK monetary policy is the use of interest rates, set by the MPC. The theory is that interest rates are very effective in controlling inflationary pressures. The relative success of meeting the government’s inflation target in the past 7 years suggests that this proves the effectiveness of monetary policy.
In brief raising interest rates helps to reduce Aggregate demand in the economy. When interest rates are raised several things are affected. Firstly those with mortgages have higher monthly payments, this reduces their disposable income and reduces their spending. Secondly there is an increased incentive to save money rather than spend. Thirdly those who have other forms of borrowing will be hit with increased interest repayments, it will also discourage people from buying on credit. Therefore in principal raising interest rates will reduce demand and prevent the economy from overheating. This enables inflationary pressures to be subdued.
» Read more: UK Monetary Policy: Does it Work