Explain how equilibrium interest rates are determined in an economy.

Discuss whether an increase in interest rates is the most effective way of reducing the rate of inflation in an economy.

Answers may include:

• definition of interest rates
• diagram to show the demand and supply of money
• explanation of the interaction of supply and demand in determining interest rates. An explanation of the role of the central bank in determining interest rates
• examples of changes in interest rates.

Marks should be allocated according to the Paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of interest rates and rate of inflation
• diagram to show how an increase in interest rates will reduce AD, leading to a decrease in the price level
• explanation of how an increase in interest rates will reduce borrowing and spending, leading to a reduction in C and I
• examples of interest rate policy
• synthesis or evaluation (discuss).

Discussion may include: the limitations of monetary policy like time lags and the independence of the central bank. Also, the effectiveness of monetary policy may be reduced if inflation and interest rates are already very high. In addition there may be reference to alternative policies like fiscal policy and supply-side policies.

Marks should be allocated according to the Paper 1 markbands for May 2013 forward, part B.