I like how you put them all together. Obviously, supply and demand aren’t always in perfect balance with each other, but understanding the concepts is a good start. (speaking of supply and demand, my boss was just wondering why anybody would put Red Delicious apples in a gift basket. We decided that since they weren’t popular (in our opinions), they were probably cheaper).

This is the standard explanation given out by economists. However, if you have not been taught this and you looked at it rationally then, surely, higher interest rates charged by the banks actually leads to higher prices. Why? Because the producers of the goods and services, who borrow the money from the banks, have higher costs associated with servicing those loans used in producing the goods and services. And because the producers are in the business of making profit then they have to pass on to the consumer the additional higher costs in the prices charged for the goods and services. So higher interest rates must lead to higher prices (or inflation, if you want to call it that)

like ur article but you missed out the point where it all goes wrong… that is.. when the interest rates are increased to decrease inflation but the high cost of borrowing for businesses & sellers is passed on to the customers resulting in inflation after all …

sir i have liked your article but i cant understand that consumption of basic goods like vegetable does not depend on money inflow in market ie even if it goes cheaper people wont consume more than normal level then how money inflow in market will affect their prises

I was an economics major and I have never heard the relationship or interest rates, inflation and supply of money explained so well.

While the central bank sets the rate at which banks can borrow from it they don’t set interest rates. The central banks actions often have quite a large influence on short term interest rates. Long term interest rates however, are much less controllable, and while affected by they central banks decisions, often have the opposite effect that people think (the central bank lowering the short term rates at which banks can borrow stoke fears of inflation and can actually result in increased long term rates).

@curious cat:
I agree that the effect on high street rates can be masked by other factors, and that long term rates move differently compared to short term rates. However, in the UK most people don’t have long term fixed mortgages or loans, so it’s reasonably likely that changes in the Bank of England’s interest rates will affect high street rates.

Unless of course your in a credit crunch but then, it’s still the money supply that effects high street rates, simply that the people with the money are hoarding it rather than lending it out. I think.

I agree with russell nov 28 and add that as well as causing inflation an increase in interest rates causes an increase in exchange rate and an outflow of money through cheapened imports
Plonkees explanation/theory only works in a closed economy
The real cause of inflation is an increase in govt regulation making it more difficult to enter an industry ,reducing competition and increasing costs.

I really appreciate the article as it theoritacally clearifies the concept retated with interest and inflation. But in the practical world how far is it applicable since people cannot lower their demand of basic needs even if they don’t have enough money and the producers will surely pass their increased cost of production on to the consumers resulting in a reverse effect.

Good work with this explanation Plonkee. It might be an interesting idea to do a new version for what happens if we get zero interest rates (i.e. look into ‘real’ interest rates). We could be going that way, after all, and that’s even harder to explain than normal interest rates and inflation…

… notice the conflicting opinions on what causes what,

I, too, was an economics major for awhile, actually at MIT while Paul Samuelson was there. I switched out because I came to the conclusion that, as Hulk Hogan said in Rocky 3, “It’s all FAKE meatball !”

Good post! Thanks for clearly explaining the relation between inflation and interest rate.

Interesting and very handy for me. I guess this kind of thing is monitored more and more now as people went out of their way to get quick loans and mortgages it affects this kind of thing as well?

It’s all well and true about interest rates,BUT, my question is, who makes the money when the interest rates go up. As a home borrower of money to buy my home, the interest rates go to 14% where does the money go to,considering I started out at 4%,why can’t we have a fixed rate for home loans, if you want to borrow money for luxury items then this should be variable rate, or the rate of the day.Is my interest money going to some one to make them richer.

The producers will surely pass their increased cost of production on to the consumers resulting in a reverse effect..

producers will only have an increased in cost of production if they are outputing at the same level prior to interest rates rises right? but if interest rates rise, then consumer demand falls, so in reality producers actually have to cut back on production in order to clear their stock inventories… doesn’t this mean that their cost of production remains more or less the same, because although they are borrowing at a higher interest rate, they are paying less to produce at a lower output rate- hence, the effect of cost push inflation is negated? can someone please explain this to me.. i find it hard to understand