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My understanding of the interest rates part of monetary policy is the follows:

Borrower's point of view:

An increase in interest rates, increases the cost of borrowing, which may reduce disposable income, causing a reductiong in aggregate demand. The equillibrium between supply and demand will therefore need to be adjusted resulting in a lower average prices (less inflation).

Saver's point of view:

As interest rates rise, the reward for saving increases, therefore people are incentivised to save their money, which may cause a decrease in disposable income and less inflation.

However, I have a question in my textbook which says how can a rise in interest rates cause higher inflation in the short term, and I'm not sure.

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If mortgage payments are included in the basket of goods that are used to calculate inflation, then rising interest rates will increase mortgage payments, causing an increase in inflation in the short term. This happens before any of the disinflationary effects show up in the data.

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Businesses have debts or liabilities, interest is an expense that's likely to be passed on to consumers in the form of increased commodity prices. This will result in inflation in the short term.

Individuals have home loans, personal loans, interest expenses of those will also increase with higher interest rate.

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Raising interest rate from a low level will increase borrowing and spending in light that the economy will raise and thus cause the inflation in short term within a range of seven years. And then when the rates are raised to a level that exceed the tolerance of economic bubble, and demand-supply relation rules in which cause final deflation. Different factors comes into play at different stages in a cycle: expectation, bubble, tolerance, demand-supply.

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  • $\begingroup$ You might need to explain why raising interest rates will increase borrowing $\endgroup$
    – 410 gone
    Apr 7, 2016 at 9:56
  • $\begingroup$ I think within a range, raising interest rate will imply the rate will continue raise further, so business would rather borrow now than later with higher cost, speculators will borrow now to gain profit from the spread. $\endgroup$
    – xappppp
    Apr 7, 2016 at 15:53

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