The Central Bank can use various different methods for reducing inflation. At the moment, the Bank Of England primarily uses changing the rate of interest (base rate) to keep inflation within the govt target of 2% + / – 1
The Monetary Policy Committee meet every month to set interest rates based on future predictions of inflation. Monetary policy is pre-emptive; this means they try and reduce inflationary pressures before they build up. To reduce inflation the MPC can increase the base interest rate. This will lead to a general rise in interest rates. This will make borrowing more expensive and savings more attractive, therefore consumption and investment will fall, causing AD to increase at a slower rate and help reduce inflation.
The first difficulty is predicting future inflation trends. According to current economic trends there may be no threat of rising inflation and therefore the MPC will leave interest rates unchanged. However, if there is an unexpected increase in AD, (e.g. due to rising house prices or higher confidence) inflation may increase before they have time to increase interest rates. This problem may be exacerbated by the problem of time lags. If interest rates are increased, it may be a while before this has an effect of reducing AD. For example, firms will not stop current investment projects, but higher interest rates may deter future investment projects.
Higher interest rates may also be ineffective in reducing inflation if other components of AD are rising. E.g, in the late 1980s, higher interest rates were initially ineffective in reducing AD because consumer confidence was very high and people were still willing to borrow despite the higher interest rates.
If there is a supply side shock in the economy it may prove more difficult to reduce inflation because higher interest rates will cause an even bigger fall in real GDP
If there was a significant increase in the price of oil LRAS would shift to the left causing higher inflation and lower Real GDP. To reduce inflation using interest rates would cause lower AD and therefore a bigger fall in Real GDP to Y3, this might be politically unacceptable.