// you’re reading...

banking and economics

how do interest rates affect inflation?

WSA adsense code -->

John commented on a previous post about the importance of the Bank of England’s interest rates:

I suggest you write an article about how interest rates effect inflation and vice versa. Something practical for the masses.

It sounded like a good idea to me, so here goes:

supply and demand in pancakes,… or anything else

Imagine people selling pancakes. If there is a big demand for pancakes, but there aren’t many people supplying pancakes then the prices will go up as the customers outbid each other for pancakes. If there is a big supply of pancakes, and not a lot of people demanding pancakes, then the price of pancakes will go down as the pancake sellers undercut each other.

Now what is true for pancakes is also true for the relationship between money and prices. If there is more money than there are goods and services to buy, then the prices for the goods and services will go up. If there is less money than there are goods and services to buy, then the prices for the goods and services will go down. The measurement of the change in prices over time (the rate at which prices change) is inflation.

the price of money

This is where interest rates come in. One of the ways that you can think about interest rates, is as the price of money. If you look at something like zopa* or prosper*, you get borrowers saying how much interest they’re willing to pay (what price are they willing to pay for money) and you get lenders saying how much interest they want to charge (what price are they willing to sell money for).

As I’ve explained before the interest rate, or the price of money overall, in a currency is effectively determined by the central bank - such as the Bank of England, the European Central Bank or the Federal Reserve for example. This means that if the central bank’s interest rates are high, money is more expensive, and if the central bank’s interest rates are low, then money is cheaper.

bringing it all together

As with all things, if money is expensive then it will tend to be in short supply, and if money is cheap it will tend to be in plentiful supply. But as we saw before, if money is in short supply [interest rates are high] then prices overall will go down [inflation is low or negative], and if money is in plentiful supply [interest rates are low] then prices overall will go up [inflation is high].

This is why higher interest rates tend to lead to lower inflation; and lower interest rates tend to lead to higher inflation.

*these are affiliate links, regular links are zopa and prosper

Similar Posts:

If you like what you're reading, why not leave a comment below, subscribe to my feed, or check out some of my best posts.


22 comments for “how do interest rates affect inflation?”

  1. 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).

    Posted by Mrs. Micah | November 27, 2007, 4:13 pm
  2. 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)

    Posted by Russell | November 28, 2007, 9:55 am
  3. 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 …

    Posted by Mr. A.Wasae Shaikh | April 15, 2008, 12:02 pm
  4. 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

    Posted by shyam | July 9, 2008, 10:34 am
  5. I was an economics major and I have never heard the relationship or interest rates, inflation and supply of money explained so well.

    Posted by chris | July 13, 2008, 7:57 pm
  6. 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).

    Posted by Curious Cat Investing Blog | July 14, 2008, 2:52 pm
  7. @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.

    Posted by plonkee | July 14, 2008, 6:17 pm
  8. 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.

    Posted by garth | July 21, 2008, 8:39 am
  9. 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.

    Posted by Himel | September 19, 2008, 7:00 am
  10. 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…

    Posted by Monevator | November 12, 2008, 1:06 am
  11. … 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 !”

    Posted by Dennis | May 1, 2009, 1:50 pm
  12. Good post! Thanks for clearly explaining the relation between inflation and interest rate.

    Posted by Steve | June 25, 2009, 9:09 am
  13. 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?

    Posted by Frank | January 28, 2010, 5:02 pm
  14. 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.

    Posted by steve | August 21, 2010, 8:32 pm
  15. The producers will surely pass their increased cost of production on to the consumers resulting in a reverse effect..

    Posted by printing | October 1, 2010, 8:46 am
  16. 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 :)

    Posted by economicsstudent | November 4, 2010, 1:37 pm

Post a comment

Proud member of the