Inflation and Interest Rates

Inflation and interest rates are in close relation to each other, and frequently referenced together in economics. Inflation refers to the rate at which prices for goods and services rise. Interest rate means the amount of interest paid by a borrower to a lender, and is set by central banks.

Since we also talk about inflation, a good example could be the following situation. Let’s say the overall price level of products offered in a market increased by 3% during the past 12 months. If a household spent $1,000 during the first month for all household expenses, then they must budget $1,030 during the last month for exactly the same quantity of goods and services. Prices of individual items may have increased at different rates and some prices may have even declined, but overall they must budget about $30 more per month now. If their income after taxes does not increase by that amount, they must save less, substitute less expensive items, or incur debt.

Understanding the relationship between money, inflation and interest rates, requires grasping the difference between the nominal and the real interest rate. The nominal interest rate is the one offered by your local bank. For example, if you have a savings account, the nominal interest rate shows how fast the amount of money in your account will increase over time. On the other hand, the real interest rate corrects the nominal rate for the effect of inflation, thus showing you how much the purchasing power of your savings account will rise over time.

Fisher effect

Irving Fisher proposed that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher Effect is shown by this equation: r = i − π. This means, the real interest rate (r) equals the nominal interest rate (i) minus rate of inflation (π). So if your bank account pays you 3% a year in interest on your deposits, but inflation over the next year increases the price level by 1%, then although you have 3% more dollars a year from now, you only have 2% more purchasing power.

In general, as interest rates are lowered, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to have less money to spend. With less spending, the economy slows and inflation decreases.

 

Interest rates ^ = bondholders stand to lose as they might have had better investing opportunities.

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