The central bank of Ostrania raises its main policy interest rate from 4% to 7% per year, in an attempt to bring the inflation rate down from 9% toward its target of 3%. A small trading company in Ostrania has an outstanding bank loan of $80,000 at a variable interest rate that…

Answer: ((a)) Monetary policy is the use of changes in the interest rate, the money supply and/or the exchange rate, generally by a central bank, to help the government achieve its macroeconomic aims. ((b)) Interest at 4%: 0.04 × 80,000 = 3,200, i.e. $3,200. Interest at 7%: 0.07 × 80,000 = 5,600, i.e. $5,600. Increase =5,600-3,200=2,400, i.e. $2,400. ((c)) A higher interest rate makes borrowing more expensive and saving more rewarding, so households and firms borrow and spend less and save more; lower spending on goods and services reduces demand in the economy, which slows the rate at which prices rise, helping bring inflation do…. Part (a): Defining monetary policy Monetary policy is the use of changes in the interest rate, the money supply and/or the exchange rate, typically carried out by a central bank, to help a government achieve its macroeconomic aims (such as…

IGCSE Economics 0455: Interest Rates, Monetary Policy and Inflation

Part (a): Defining monetary policy

Monetary policy is the use of changes in the interest rate, the money supply and/or the exchange rate, typically carried out by a central bank, to help a government achieve its macroeconomic aims (such as low, stable inflation).

Part (b): Calculating the increase in interest cost

At the original interest rate of 4%, the annual interest on the $80,000 loan is: $0.04 \times 80{,}000 = 3{,}200$ so the annual interest cost is $3,200.

At the new interest rate of 7%, the annual interest on the same loan is: $0.07 \times 80{,}000 = 5{,}600$ so the annual interest cost is $5,600.

The increase in annual interest cost is: $5{,}600 - 3{,}200 = 2{,}400$

So the interest rate rise increases the company’s annual interest cost by $\boxed{2{,}400}$ , i.e. $2,400.

Part (c): Explaining the effect on inflation

Raising the interest rate makes borrowing more expensive, as shown by the company’s higher loan repayments above, and makes saving more attractive because savers earn a better return. Facing higher borrowing costs, households and firms tend to spend and invest less, and more people choose to save rather than spend. Because total spending in Ostrania’s economy falls, demand for goods and services eases, which slows down the rate at which firms need to raise their prices, helping bring the inflation rate down from 9% toward the central bank’s 3% target.

Final answers

(a) Monetary policy is the use of changes in the interest rate, money supply and/or exchange rate to help meet the government’s macroeconomic aims.
(b) Increase in annual interest cost $=$ $2,400.
(c) Higher interest rates raise the cost of borrowing and reward saving, cutting spending and demand, and so slow inflation.