Nov

27

how do interest rates affect inflation?

Filed Under banking and economics 

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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Comments

3 Responses to “how do interest rates affect inflation?”

  1. Mrs. Micah on November 27th, 2007 4:13 pm

    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).

  2. Russell on November 28th, 2007 9:55 am

    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)

  3. Mr. A.Wasae Shaikh on April 15th, 2008 12:02 pm

    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 …

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