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well, it does two things to inflation.

Firstly it increases the costs of production of firms therefore shifting Aggregate supply inwards (thereby increasing cost push inflation).

It also shifts aggregate demand inwards because firms and households are less likely to want to borrow money in the case for consumption and investment because it increases their costs (this particularly affects the housing market and other big ticket items). This reduces the effects of demand pull inflation.

So it shifts aggregate supply and aggregate demand inwards.

When AS shifts inwards inflation increases.

When AD shifts inwards inflation decreases.

So the government would have to decide what the best policy is to do. Generally the shift inwards in AD will have a bigger effect on inflation (especially because the decrease in consumption which accounts for 60% of AD will hit consumers more - in mortgages) and also the effect will be maximised if the part of the AS curve is inelastic meaning an almost vertical drop in the general price level.

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Q: What happens when interest rates increase?
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