plonkee money an english-er's thoughts on personal finance

November 27, 2007

how do interest rates affect inflation?

Filed under: banking and economics — plonkee @ 12:00 pm

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

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