Explain the use of interest rates in the economy.

Interest Rates are a tool used by the Bank of England in the UK in order to control inflation and keep it to the 2% aim. Interest rates work in two main ways, supposing the interest rates rose from 0.25% to 0.5% which would firstly increase the return on savings. This would provide incentive for the consumer to put their money in a commercial bank, as the base rate (rate at which commerical banks borrow from the central bank) has increased, which would be passed on by commercial banks to the consumer thus resulting in a consumer surplus. Secondly, this would increase the cost of borrowing, as the interest rate paid to "service" a debt would increase (affecting especially potential homeowners). The overall effect would be to act as a net leakage from the circular flow of income, and reduce AD, which (using a macro diagram) would decrease the Price Level and so inflation.