VirtualSC Economics CP Practice Exam

Raising interest rates is an effective policy to combat high inflation because it makes borrowing more expensive and saving more attractive. When the central bank raises interest rates, it directly impacts the cost of loans and credit. Higher interest rates discourage consumer spending and business investments, which can lead to a decrease in demand for goods and services. This reduction in demand helps to slow down price increases, thereby addressing the issue of inflation.

Additionally, higher interest rates can strengthen the currency as they tend to attract foreign investment, which can also help reduce import costs and further alleviate inflationary pressures. By tightening monetary policy in this way, the central bank aims to bring inflation back to a target level, typically set around 2% in many developed economies.

In contrast, other options such as increasing government spending, lowering interest rates, and reducing taxes tend to boost aggregate demand in the economy, potentially exacerbating inflation rather than controlling it. These actions are generally associated with stimulating the economy rather than cooling it down during periods of high inflation.