How do Interest Rates Affect Inflation?

By BankBazaar | March 14, 2016

How do interest rates affect inflation?

Design credits: Rakesh Mohan

Inflation, by definition, is an increase in the price of goods and services within an economy. It’s caused due to an imbalance in the goods and buyer ratio – when the demand of goods or services in an economy is higher than the supply, prices go up. Hard to believe, but inflation isn’t necessarily a bad thing. It’s often an indicator of a robust economy and the government usually takes into account a yearly rate of 2% to 3% when it comes to an increase in inflation.

The interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from creditors.

How do interest rates affect the rise and fall of inflation?

So how do these seemingly unrelated topics come together? Let’s find out:

  • Lower interest rates translate to more money available for borrowing, making consumers spend more. The more consumers spend, the more the economy grows, resulting in a surge in demand for commodities, while there’s no change in supply. An increase in demand which can’t be met by supply results in inflation.
  • Higher interest rates make people cautious and encourage them to save more and borrow less. As a result, the amount of money circulating in the market reduces. Less money, of course, would mean that consumers find it more difficult to buy goods and services. The demand is less than the supply, the hike in prices stabilise, and sometimes prices even come down.

A growing economy might sound like music to your ears, but if you think about it, an economy growing at an alarming rate might not really be the best thing. The associated inflation, among other things, would be something to worry about as prices would escalate. This is not a risk that a volatile economy like ours can take. It is at times like this that the RBI steps in and, using indices like consumer price index (CPI) and wholesale price index (WPI), tries to reign in growth by increasing interest rates. Economic growth (or the lack of it) has a huge impact on society as well. The RBI, thus, keeps a strict eye on current economic trends with the aim to maintain balance. There must be enough economic growth to ensure high pay and low unemployment, but not in such leaps and bounds that it would lead to dangerously high inflation. In a stable and healthy economy, wage and inflation rise in tandem.

Additional reading: 7 golden ways to beat inflation woes

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