“Macroeconomics” deals with the “big picture” of how things fit together in the economy as a whole, while “microeconomics” deals more with how it affects the individual. Here at InflationData, we generally look at the macro side and leave the economics of the individual to our sister sites like Your Family Finances. Today we are going to look at the macroeconomic implications of the link between inflation and Interest rates. ~Tim McMahon, editor
The Macroeconomic Link Between Inflation and Interest Rates
By George J. Newton
Price Inflation is the rate at which the price of goods and services rises in the economy over a period of time. Monetary inflation is the increase in the money supply via government action such as Quantitative easing. Interest rates differ by country; but in the United States, the prime interest rate is based on a rate determined by the Federal Reserve called the federal funds rate. According to Wikipedia, “In the United States, the federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis.”
Interest rates are the fees charged to a borrower for the privilege of borrowing money based on the creditworthiness of the borrower and the amount of time the money will be on loan. Inflation has some effect on Interest rates because a lender must charge more interest during high inflation periods because he needs to cover the loss of purchasing power between the time he loans the money and when he receives it back.
So, What are the Economic Connections?:
Overall, interest rates and the rate of inflation in an economy usually have what we like to call an ‘inverse’ relationship. Summer Raye, a business journalist at Britstudent and Write My X, noted, “For the most part, when interest rates are particularly low, the economy will grow. This is because people will borrow more money, there will be more economic activity, and the economy will grow and expand over this period of time.” However, when interest rates are high, people (and businesses) will stop borrowing and choose to save money, meaning economic activity as a whole will take a nosedive. Because of this principle, inflation will decrease when interest rates are high, and increase when they are low; and this is all due to the fact that interest rates are a big influence on economic activity. The Federal Reserve has in the past used this inverse relationship as a crude tool to dampen inflation after they have increased the money supply. The FED does this by raising the aforementioned FED Funds Rate.
So, let’s talk about this inverse correlation between the two –
This correlation between interest rates and inflation can lead to one dangerous thing. Central banks often manipulate and play around with the interest rate to affect inflation. This is a regular occurrence and is why the economy has so many ups and downs. Overall, a reduction in interest rates means that people borrow more money and then spend more money. This action causes inflation in the economy to go up. The opposite then occurs for rising interest rates. Not only do customers not borrow money, but they tend to save more because savings invested return more money at the same time. Disposable income spending goes down, and then the economy slows and inflation goes down.
Fractional Reserve Banking –
Tania Hardy, a business writer at Phdkingdom and 1day2write, says, “The fact that the interest rate and the rate of inflation has the converse relationship that it does is largely down to the fact that there is a fractional reserve banking system.” To put it simply, let’s say someone deposits $100 into the bank. The bank keeps a ‘reserve’ of 10% of that money in the bank and then loans out the other 90%. However, the person who deposited that money into the bank still has that $100. They have access to it, and they can lay claim to it. But the bank has taken $90 and lent it out to someone else. Because of this, the $100 is now actually $190. The money supply itself has increased. The only time this becomes a problem is when the economy crashes. As an overall system though, this process works because it keeps the economy not only running but growing.
Interest Rates, Loans, and Savings…and Inflation!:
An economy’s interest rate represents the cost of holding, loaning, or borrowing money. Banks offer an interest rate on people’s savings in order to attract people to deposit their money in the bank. This means that the bank has access to that money to loan out, which is good for the bank and those who can use the additional money to invest productively, while those who use loans to purchase consumer goods benefit the companies selling the consumer goods, the consumer himself ends up paying more for the item than if he had waited and purchased it interest-free. However, in times of high inflation people are encouraged to spend quickly (and borrow if the interest rate is low enough) because they fear decreased purchasing power in the future. The faster people try to “unload” their money the higher the Velocity of Money. A high velocity of money can also result in more inflation because although the quantity of money hasn’t increased it seems like it has because it is moving around the economy so fast.
Banks receive interest on the money that they loan out. When interest rates are particularly low, people want more loans, thus increasing the money supply through the fractional reserve system. This can be another factor in increasing the money supply.
About the Author:
George J. Newton is a business development manager and content writer for Write My Dissertation and Thesis Help. He has a patient and long-suffering wife of over a decade, who is his biggest supporter and friend. He also contributes his work to Do My Coursework.
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