An increase in interest rates- the cost of debts to a borrower- are an example of a contractionary

monetary policy. Monetary policy refers the control of money supply and interest rates by the central
bank, and a contractionary monetary policy- policies to reduce money supply and increase interest
rates- are often used to combat inflation. Inflation is defined as a persistent increase in the average price
level of an economy over a period of time.

As shown on the diagram, a reduction in interest rates

will cause aggregate demand to shift left. This is because
an increase in interest rates will reduce the incentive to
borrow and for consumers and incentivize them to save
money and receive higher returns. This is because the
cost of borrowing increases and the returns from
savings increase.
This decrease in aggregate demand from AD1 to AD2
causes a fall in the price level from P1 to P2 and hence
leads to a decrease in the rate of inflation in the
economy.

Some of the primary benefits of monetary policy is that there is reduced bureaucracy and quick
implementation of the policy. This is because interest rates are not controlled by the government, but
rather the central bank. Moreover, there are no political popularity problems because the government
do not determine interest rates. Also, many big sectors are affected by monetary policy such as housing
and automobiles, because such goods tend to be bought when interest rates are lower because as such
the cost of borrowing is lower. As such, interest rates are an effective mean to control inflation.
However, there is a long-time lag in affecting AD with interest rates because interest rate-based
decisions are long time (e.g. buying a house). Moreover, influencing interest rates can require the
cooperation of commercial banks, because they are more focused on achieving their own profits than
macroeconomic goals. Moreover, the contractionary monetary policy by increasing interest rates could
lead to a reduction in Real GDP and hence negative economic growth. This is seen in the diagram since
there is a fall in Real GDP from Y1 to Y2.
Changing interest rates has various effects on different stakeholders. Consumers will be more
incentivized to save than to spend because interest rates will put off investments, hence their purchasing
power for investments such as homes and cars will be decreased. For firms, they could be worse off
because the decrease in the aggregate demand can lead to less output being produced and hence lower
profit margins. Moreover, due to firms having reduced output, workers may lose their jobs.
Alternative policies to solving the inflation could be a contractionary fiscal policy. This is a reduction in
government spending and an increase in taxation. This has a drastic effect on AD, reducing it more
immediately than controlling interest rates, because the incomes of people will be reduced while the
cost of goods will be increased. This fall in AD will lead to the price level falling and inflation being
corrected. An economy could use a combination of the two policies to combat inflation.
The overall effectiveness of increasing interest rates depend on the time period and magnitude. A time
lag is inevitable and in the short-term inflation may not be solved as rapidly. However, in the long term
the rate of inflation will be significantly reduced. Moreover, if the increase in interest rates is not large
enough, the policy may not be too effective in reducing inflation. However, if the interest rates are
increased too much, it can have potential damaging effects on the economy and thus must be well
controlled and monitored.

More points:
Tends to hurt the poor more, increases income inequality
Progressive tax systems
MPC for richer people