The article describes the situation in
Mexico where the central bank has raised its interest rate to 7% in order to
try and lower inflation to a target goal of 3%.

 

Inflation is defined as ‘a persistent increase in the average price
level in the economy’. A low and stable rate of inflation is desired by
governments in order to satisfy the macroeconomic goal of price stability, this
rate is estimated to be around 2%. This will stimulate the consumers to keep
spending their money, which is the most vital part of the business cycle. Mexico
currently has an inflation rate of 6.3%, which is too high.

 

In order for the inflation to be reduced,
the aggregate demand has to go down as well. The macroeconomic aggregate demand
measures the total demand within a economy taking into consideration the
average price level of all goods and services, and the total quantity of all
goods and services produced, also known as the ‘national output’. 

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In pursuance of managing
the aggregate demand banks often chose to lower or higher the interest rate. When
people want to buy durable goods, which are goods that do not wear out quickly
and can be used for long periods of time, such as houses or cars. People often
have to borrow money from the bank in order to be able to afford these
products. Borrowing this money has a cost, as they have to pay interest to the
bank.

 

If there is a higher interest rate, which
basically determines the price of borrowed money, then people will be less
likely to borrow (as it is more expensive when they have to pay the bank back).

This relationship is illustrated in graph 1.0. As the interest rate goes up,
the amount of borrowed money will go down and less people will be able to make
investments.

People will have
less money to spend, and therefore consumption will fall, leading to the
aggregate demand that to decrease in effect, as shown in graph 2.0.

 

 

A higher interest rate
also makes saving more interesting, as people will be earning more money over
their savings in the bank. So people would rather put their extra income in the
bank whilst earning money than spending it on goods and services. This also has
an affect on the total amount of consumption, thus the aggregate demand curve
will shift inwardly, or decrease, as interest rates go up, as shown in graph
2.0.

 

 

 

 

 

 

In order to solve the high inflation, the
Mexican central bank has used monetary policies. Monetary policies are policies
that govern the supply of money and interest rates. The government central
banks, such as Mexico’s in this case, will set a base rate and banks will
increase their rate offered to their consumers based on this base rate, which
is now 7% in Mexico.

 

Hence, in order to solve inflation, the
aggregate demand has to be reduced. This can be done by reducing the money
supply, many economists believe that inflation is caused by excessive growth of
the money supply, so the solution would be to lower the money supply. When less
money is circulating within the economy, people will have less money to spend
thus decreasing the aggregate demand. In order to reduce the money supply, the
reserve requirements should be increased, which will lower the reserve amount
available for loans at banks, thus interest rates will be increased as it is
now more expensive to borrow money seeing that there is less available.

Therefore, a higher interest rate will reduce the amount of money that is
borrowed, both because it is less appealing to people to do so as well as that
there is a limited amount of money that is accessible. And thus, as less money
will be circulating within the economy, people are less likely to invest and
because people are preferring to be saving their money rather than to be
spending it as a result of increased interest rates, the consumer spending
within the economy should decrease, this as an affect lowers the prices for
goods and services as the demand is lower. And so, inflation should decrease.

 

It should also help solve the depreciation
of the peso as the high interest rates will attract foreign investors as well
as making its exports more attractive which will generate a higher trading
income besides stimulating the flow of money into the capital account.

 

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