Inflation and Interest Rates

Inflation and Interest Rates

You will learn about the following concepts

  • Inflation and interest rates in general
  • Fisher effect
  • Federal Open Market Committee and its policy
  • Effects of high inflation
  • What is deflation?
  • and more

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Inflation and interest rates are in close relation to each other, and frequently referenced together in economics. Inflation refers to the rate at which prices for goods and services rise. Interest rate means the amount of interest paid by a borrower to a lender, and is set by central banks.

To clarify what interest rates are, let’s pretend you deposit money into a bank. The bank uses your money to give loans to other customers. In return for the use of your money, the bank pays you interest. Similarly, when you purchase something with a credit card, you pay the credit card company interest for using the money that paid for your purchase. In general, interest is money that a borrower pays a lender for the right to use the money. The interest rate is the percentage of the total due that is paid by the borrower to the lender.

Example

pencilSince we also talk about inflation, a good example could be the following situation. Let’s say the overall price level of products offered in a market increased by 3% during the past 12 months. If a household spent $1,000 during the first month for all household expenses, then they must budget $1,030 during the last month for exactly the same quantity of goods and services. Prices of individual items may have increased at different rates and some prices may have even declined, but overall they must budget about $30 more per month now. If their income after taxes does not increase by that amount, they must save less, substitute less expensive items, or incur debt.

Understanding the relationship between money, inflation and interest rates, requires grasping the difference between the nominal and the real interest rate. The nominal interest rate is the one offered by your local bank. For example, if you have a savings account, the nominal interest rate shows how fast the amount of money in your account will increase over time. On the other hand, the real interest rate corrects the nominal rate for the effect of inflation, thus showing you how much the purchasing power of your savings account will rise over time.

Fisher effect

Irving Fisher proposed that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher Effect is shown by this equation: r = i − π. This means, the real interest rate (r) equals the nominal interest rate (i) minus rate of inflation (π). So if your bank account pays you 3% a year in interest on your deposits, but inflation over the next year increases the price level by 1%, then although you have 3% more dollars a year from now, you only have 2% more purchasing power.

From the Fisher equation, you can see that if the real interest rate is held constant, an increase in the inflation rate must be accompanied by an equal increase in the nominal interest rate. The Fisher Effect is an evidence that purely monetary developments will have no effect on the country’s relative prices in the long run. In the short run, the Fisher Effect does not necessarily hold since the nominal rate might need time to adjust if the inflation was unexpected.

Fisher+Effect

In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to have less money to spend. With less spending, the economy slows and inflation decreases.

FOMC and interest rates

Federal_Open_Market_Committee_MeetingThe Federal Open Market Committee (FOMC) meets eight times each year to review economic and financial conditions and decide on monetary policy. Monetary policy refers to the actions taken that affect the availability and cost of money and credit. At these meetings, short-term interest rate targets are determined. Using economic indicators such as the GDP Deflator, Consumer Price Index(CPI) and the Producer Price Indexes (PPI), (which would be explained in following articles) the Fed will establish interest rate targets intended to keep the economy in balance. By moving interest rate targets up or down, the Fed attempts to achieve maximum employment, stable prices and stable economic growth. The Fed will raise interest rate, or act hawkish, to decrease inflation. Conversely, the Fed will decrease rates, or act dovish, to accelerate inflation and spur economic growth.

Investors and traders keep a close eye on the FOMC rate decisions. After each of the eight FOMC meetings, an announcement is made regarding the Fed’s decision to increase, decrease or maintain key interest rates. Certain markets may move in advance of the anticipated interest rate changes and in response to the actual announcements. For example, the U.S. dollar typically rallies in response to an interest rate increase.

It is of great significance for consumers and businesses alike to feel secure that inflation is held under control and prices will, in general, rise only very gradually, if at all. Price stability means that a single unit of a currency will buy roughly the same amount of goods the next month, or in a year, as it buys today. Severe inflation or deflation lead to insecurity and damage economic sentiment, which is why price stability is deemed a necessary requirement for a healthy economy.

Effects of high inflation

inflationRapidly rising prices diminish purchasing power, which causes people to eventually start demanding higher payment. In order to offset the rise in pay, companies will, in turn, include the wage increase into the prices of their products. This will result in a further rise in prices, thus forming a vicious spiral with wages and prices pushing each other up. An environment, where prices of both goods and services keep growing more and more, leaves individuals and companies without solid ground to base sound economic decisions on. It is therefore imperative to establish security and confidence by implementing a stability-ensuring monetary policy, in order to achieve sustainable economic growth.

Deflation

deflationWhile central banks try to avoid high inflation, the opposite, deflation, also bears a negative effect on the economy. It goes hand-to-hand with increased unemployment since there is a lower level of demand in the economy. Individuals and companies tend to refrain from purchasing new goods, especially durable goods, amid expectations that the same items will cost less tomorrow, due to the deflationary pressure. This condition can lead to an economic depression. Declining prices, if occurring as a persistent effect, tend to form a vicious spiral of negatives such as falling profits, which lead to the closure of factories. This on the other hand raises the unemployment rate and shrinks personal income, further weighing on spending and retails sales, and increasing defaults on loans by companies and individuals.

Central banks attempt to counter both severe deflation and inflation in order to minimize the excessive instability in prices. To avoid deflation for example, the Federal Reserve can use monetary policy to increase the money supply (something which we will thoroughly explain further in the chapter) and deliberately spur inflation by inducing rising prices. The jump in prices on the other hand provides ground for a sustained recovery because as the businesses’ profits jump, they take some of the depressive pressures off wages and debtors.

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