Broadly speaking, inflation is a general rise in the price of goods and services in the economy. It normally comes up when there’s a mismatch between supply and demand in the economy. When something happens in the economy to make demand greater than the supply of goods, inflation may arise. Inflation has many interesting connections with the economy’s interest rate.
Interest rate is the amount of money a lender charges for a borrower to use their assets. It is a percentage of the principal value of the assets. The interest rate, to some level, reflects the money in circulation in an economy.
A lower interest rate implies more money in circulation, meaning consumers are spending more. It is generally understood that the more consumers spend, the bigger an economy will grow.
Economic growth is synonymous with increased demand. Sometimes, this demand may not be fully satisfied by the supply in the economy, leading to inflation.
But when interest rates are high, borrowing reduces. As the access to credit drops, people are more careful about where they spend their money so consumption reduces. As a result, the money in circulation reduces as well. This makes demand lower and any previous increase in prices will stabilize.
Relationship between interest rate and inflation
As we can see, low-interest rates create greater purchasing power for the consumer. The more people buy goods and services, the higher the chances that their prices will increase, leading to inflation. Governments are aware of this and if economic growth is too fast, measures will be put in place to bring things under control. One of these policies is to increase interest rates. The effect is that the amount of money entering the economy reduces.
Inflation is not always bad. Moderate inflation presents some positive impacts on the economy. For instance, it lowers the real value of debt. This means that it becomes easier for borrowers to repay loans. In fact, it stimulates people to take out more loans for investment.
The price of goods is an important economic index for both customers and sellers. Price stability is a goal for most healthy economies. The supply and demand for money determine the inflation rate in the economy.
Similarly, the interest rate plays a major role in setting the price of holding or lending money. When customers open up bank accounts, they can expect to receive some interest on their savings. When banks lend out money, they impose an interest rate on the loan.
Low-interest rates stimulate businesses and individuals to borrow more money. With every loan taken out, the money circulation in the economy increases. As the supply for money increases, it is generally understood that inflation arises due to increased demand that can’t be sustained by the current supply. Low-interest rates normally result in more inflation. The remedy is normal increasing the interest rate to lower inflation.
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