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Relationship between Interest Rates and Inflation

Financial Management

Submitted by:- Anshul Khanna

Reg no. 1422101
Sub:- Financial Management
MBA Ex Semester 2

The Relationship between Real Interest Rates and Inflation

Abstract
In the recent decade, a huge amount of papers, describing monetary
policy rules based on nominal interest rates, has been written. As it
is, however, well known, it is a fact that interest rate can influence
spending decisions of enterprises and households and thus inflation.
One way, to describe the relationship between real interest rates and
inflation, is based on our experience with the monetary theory of the
price level. Interest rates and inflation usually work in tandem. Rates
tend to rise when the inflation goes up and tend to fall when it comes
down. Understanding why that happens can help us decide whether
to borrow money, plan to pay back loans and anticipate whether life
is going to get more expensive. Though some connections between
interest rates and inflation aren't obvious, their relationship usually
makes sense when we look at real-world examples.

Introduction:For many years money has been a central issue in monetary policy
making. Central banks used to set monetary targets and academics
used to teach monetary policy, as a story about how central bankers
adjust the money supply. Even the name of the main activity of
central banks took its origins from the word money. Thus, it is no
wonder that many economic papers describing inflationary
phenomena still assume that central banks control the money supply.
However, the world is changing, and targeting monetary aggregates

becomes less and less fashionable. The main reason is probably the
growing instability of money demand functions.
In reaction, monetary authorities move from targeting the money
supply towards controlling nominal interest rates at the money
market. As a result, in the recent decade, a huge amount of papers,
describing monetary policy rules based on nominal interest rates, has
been written.
Inflation and interest rates are linked, and frequently referenced in
macroeconomics. Inflation refers to the rate at which prices for
goods and services rises. In the United States, interest rates the
amount of interest paid by a borrower to a lender are set by
the Federal Reserve (sometimes called "the Fed"). 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.
The Federal Open Market Committee (FOMC) meets eight times
each year to review economic and financial conditions and decides on
monetary policy. Monetary policy refers to the actions taken that
affect the availability and cost of money and credit. At these
meetings, short-term interest rate targets are determined. Using
economic indicators such as the Consumer Price Index (CPI) and
the Producer Price Indexes (PPI), the Fed will establish interest rate
targets intended to keep the economy in balance. By moving interest
rate targets up or down, the Fed attempts to achieve maximum
employment, stable prices and stable economic growth. The Fed will
tighten interest rates (or increase rates) to stave off inflation.
Conversely, the Fed will ease (or decrease rates) to spur economic
growth.

Investors and traders keep a close eye on the FOMC rate decisions.
After each of the eight FOMC meetings, an announcement is made
regarding the Fed's decision to increase, decrease or maintain key
interest rates. Certain markets may move in advance of the
anticipated interest rate changes and in response to the actual
announcements. For example, the U.S. dollar typically rallies in
response to an interest rate increase.
Inflation is the rise over time in the prices of goods and services. It's
usually measured as an annual percentage, just like interest rates.
Most people automatically think of inflation as a bad thing, but that's
not necessarily the case. No inflation, or deflation (the lowering of
prices), is actually a much worse economic indicator. Also, in a
healthy economy, wages rise at the same rate as prices.
A standard explanation for the cause of inflation is "too much money
chasing too few goods" This is also called the demand-pull theory.
Here's how it works:

1. For several possible reasons, more money is being spent than

normal. This could be because interest rates are low and people
are borrowing more. Or perhaps the government is spending a
lot on defence contracts during a war.
2. There's not enough supply to keep up with the rising demand
for homes, cars, tanks, missiles, et cetera. Manufacturers are
producing goods at a slower rate than people are demanding
goods.
3. When supply is less than demand, prices go up.

Another explanation for inflation is the cost-push theory. Here's how

that works:
1. For several possible reasons, the cost of doing business starts
to go up independent of demand. This could be because labour
unions negotiated a new contract for higher wages, the local
currency loses value and the cost of exporting foreign goods
goes up, or new taxes have put a strain on the bottom line.
2. It's called cost-push inflation because the rise in the cost of
doing business pushes the price of products up.

So how do interest rates affect the rise and fall of inflation? Like we
said earlier, lower interest rates put more borrowing power in the
hands of consumers. And when consumers spend more, the economy
grows, naturally creating inflation. If the Fed decides that the
economy is growing too fast-that demand will greatly outpace
supply-then it can raise interest rates, slowing the amount of cash
entering the economy.
It's the Fed's responsibility to closely monitor inflation indicators
like the Consumer Price Index (CPI) and the Producer Price Indexes
(PPI) and do its best to keep the economy in balance. There must be
enough economic growth to keep wages up and unemployment low,
but not too much growth that it leads to dangerously high inflation.
The target inflation rate is somewhere between two and three per
cent per year.

Borrowing Demand:When companies experience inflation they have to spend more

money to operate. They pay higher prices for supplies, raw materials,
shipping and these increased costs can cause them to borrow money
for growth and expansion rather than financing it themselves. That
makes for increased loan demand, which can cause banks to raise
their interest rates. Since they only have limited amounts to loan,
banks see the increased demand as an opportunity to make more
money from what they have. Therefore, the higher business costs
that result from inflation can translate into higher interest rates.

Profit Margins:As inflation raises the cost of doing business, banks find they make
less money on loans. Their incomes remain the same while expenses
go up, which means smaller profit margins. Consequently, banks
tend to raise rates to compensate for their increased expenses. For
example, if the cost of labour, supplies and communications rises 2
per cent for a bank, loan rates have to rise at least that much to help
income keep up with inflation.

Losing Value:Businesses and individuals like to make money on their money. If

you have $1,000, you could invest it and earn interest. If, instead,
someone wants you to loan them $1,000, you give up the interest
you could have made. Inflation means your $1,000 buys less over
time, so your money actually loses purchasing power during the loan
period. To make up for the loss of value you could charge interest on
the loan, just like a bank does. During periods of high inflation you
must charge higher interest because you have more ground to make
up when it comes to your money's value.

Default Dilemma:Borrowers can have a harder time paying back loans as inflation
rises. Their living and business expenses go up during inflationary
periods, squeezing their budgets so they have less to spend. If
income doesn't keep up with inflation, people can reach the point
where they can't pay all of their expenses. One of those expenses may
be loan payments. Default rates can rise as a result and banks may
then view the lending environment as having more risk, causing
them to raise interest rates to compensate.

Summary:Inflation is an autonomous occurrence that is impacted by money

supply in an economy. Central governments use the interest rate to
control money supply and, consequently, the inflation rate. When
interest rates are high, it becomes more expensive to borrow money
and savings become attractive. When interest rates are low, banks
are able to lend more, resulting in an increased supply of money.
Alteration in the rate of interest can be used to control inflation by
controlling the supply of money in the following ways:

A high interest rate influences spending patterns and shifts

consumers and businesses from borrowing to saving mode.
This influences money supply.

A rise in interest rates boosts the return on savings in building

societies and banks. Low interest rates encourage investments
in shares. Thus, the rate of interest can impact the holding of
particular assets.

References:-

http://www.synonym.com/
https://au.answers.yahoo.com/
http://www.decodedscience.com/
http://www.er.ethz.ch/publications/MAS_Thesis_VoznyukOlga_final_Feb10.pdf
https://www.researchgate.net/home.Home.html