This creates employment and boosts economic activity. Conversely, an increase in interest rates works in the direction of reducing demand and suppressing economic activity and employment. The second mechanism concerns the relationship between economic activity and prices.
Prices are thought to be determined by the balance between supply of and demand for goods and services in the economy as a whole, or the output gap. When the economy is booming and demand is high, there is a higher probability of a rise in the inflation rate. Conversely, when the economy is sluggish and demand is weak, the inflation rate falls.