Impact of Interest Rates on Inflation: Draft Edits

Professor First Last

Economics 211

21 November 2021

Introduction

Interest rates play a significant role in shaping a country's economy. The Federal Reserve System in the US determines the interest rates, which determine the prices of goods and services in the market (Ferreira & Shousha, 2021). The two concepts are linked, and academicians have established both direct and inverse relationships between the two concepts. Some academicians argue that since both inflation and interest rates are driven by money, they have a direct relationship such that an increase in interest rates increases the rate of inflation and vice versa. However, the money quantity theory establishes an inverse relationship between interest rates and inflation; High-interest rates reduce money circulation, which leads to a reduction in prices. On the other hand, low-interest rates increase money circulation, which increases the price of goods and services.

Literature Review

Definition of Inflation

Academicians define inflation differently. However, the most harmonizing definition of inflation is the decline in a currency's value or purchasing power. The decline takes place over time and affects the general price of goods and services in the market. When there is inflation, a currency unit buys less than what it used to but previously. For example, if the price of bread increases from $ 1 to $ 1.50, it means the value of the currency has reduced, and more money has to be used to buy bread. When there is inflation, the money supply increases in an economy faster than the production of goods and services required in the market. This leads to an imbalance between supply and demand in a country's economy.

Definition of Interest rate

Kiley & Roberts (2017) define interest rate as the amount a lender charges a borrower, expressed as a percentage of the principal. It is typically represented as an annual percentage, and the borrower pays back the principal and the interest. According to the International Monetary fund, interest rates serves three functions;

It serves as a return on the financial asset so that it can promote deferred consumption, a saving that will facilitate future activities.

It is also considered a cost of capital that will determine the amount of money that can be loaned to members of the public.

The interest rates within a country and the return rate of foreign financial assets are normally evaded against inflation.

Based on these functions, it is clear that interest rates impact the economy dramatically. It also affects other variables that will influence investment activities that shape economic growth and a country's development.

What is the relationship between inflation and Interest rate?

Different scholars establish the relationship between inflation and interest rate differently. Gunel (2017) establishes a positive relationship between inflation and interest rates based on the Fischer hypothesis. He argues that both interest rate and inflation are driven by money and affect demand and supply in an economy.

Geetha et al. (2011) pose that based on the financial theory, the inflation rate in an economy implies an increase in the price of goods and services. When there is inflation, the value of money goes down because a lot of money is chasing a few goods and services available in the market. Geetha’s concept implies that both inflation and interest rates are driven by money, and inflation will lower the demand for money. Consequently, the value at which the money was borrowed for reinjection into the production of goods and services will reduce, hence creating a positive relationship.

Although some academicians argue that there is a positive relationship between interest rates and inflation, studies indicate that the two variables are linked inversely; an increase in interest rate reduces inflation while a reduction in interest rate increases inflation. Research links interest rates to economic variables such as purchasing power, consumer spending, demand, and supply, determining market prices.

An increase in interest rate lowers purchasing power because few people have access to loans. The high-interest rates increase the value of money by increasing its purchasing power, meaning the prices will be low. On the other hand, many people can borrow loans (Brown, 2020). This increases the supply of money in the economy and lowers the marginal value of money. More money means more spending and more demand, which calls for an increase in prices (inflation).

Theoretical Framework

The quantity theory of money suggests that the price of goods and services in an economy is proportional to the money supply in that economy. If the amount of money supplies increases, then the price of goods and services also increases. For example, when the money supply increases by 20%, goods and services also increase by 20%. This implies that the consumer will have to pay 205 more for goods and services compared to what they paid before the price increase. When price increases, it will result in rising inflation. The force that shapes supply and demand for goods and services in an economy will affect the supply and demand for money (Ahiakpor, 2019). When the supply of money goes up, the marginal value of money reduces. In other words, when the supply of money increases, the purchasing value of a unit decreases if other factors are kept constant. The economy adjusts to the decrease in value by increasing the prices of goods and services.

The quantity theory of money also suggests that the amount of money available in an economy directly shapes the level of economic activities. Therefore, when there are changes in money supply, the economic activities in an economy change too. The theory also assumes that the changes in the supply of money primarily influence the changes in spending. When there is more money, people tend to spend more and vice versa. The theory implies that the value of money depends on the quantity of money available at a particular time. As the price goes up, people's spending power decreases.

Discussion

Based on the quantity theory of money, an increase in money supply leads to an increase in inflation. This happens because the value of money goes down, and the economy fixes the gap by increasing the price of goods and services to maintain equilibrium. An increase in money supply results from low-interest rates because many people borrow money that circulates within the economy. According to the theory, low-interest rates attract low values, which results in high prices for goods and services. On the contrary, high-interest rates increase the value of money, and smaller units have high purchasing power, meaning the prices will be low.

When the interest rates are lower, more people are willing to borrow so that they can invest in assets of their dreams, such as houses and cars. When the interest is low on borrowed money, there is more money to spend on making purchases. More spending implies that the money available is more than the goods and services (Borio & Hoffman, 2017). At such times, the supply of goods and services is lower than the demand, which calls for an increase in prices.

When the interest rates are high, consumers have lower disposable income, which lowers their spending. When the spending is low, the money that circulates in the economy is also low because few people borrow money. A low supply of money increases the marginal value of money, and the purchasing power of a unit increases. When the purchasing power goes up, little money is required to buy goods and services, reducing prices.

When the interest rates are high, banks give out few loans, and this affects farmers and business spending. These entities cut down their spending through strategies such as reducing the number of employees through layoffs. When employees lose jobs, their disposable income reduces, implying a reduction in their spending. When consumers reduce their spending. The demand for goods and services goes down. Consequently, the supply of goods and services is higher than what is demanded in the market. To attain equilibrium, the prices go down so that consumers purchase more and encourage suppliers to continue producing more.

A relevant example of the impact of interest rates on inflation is what occurred in the USA between 1980 and 1981. The Federal Reserve System increases the interest rates from 14% to 19%, and this causes a severe recession. At this time, there was little money to spend because very few people could borrow loans. Although e changes caused a recession, they put to end the rising inflation that the country was experiencing. When the government reduced the interest rates in 2002, it contributed to the recovery of the economy. In 2002, the Federal Reserve reduced the interest rates to 1.25%, leading to more borrowing and increased money supply. Consequently, the consumers increased their spending, and the economy started booming again.

Inflation rate

Inflation

The graph above shows an inverse relationship between interest rates and inflation. The vertical line shows the interest rate, while the horizontal line shows the inflation rates. The arrow line shows the changes in inflation and interest rate. From the above graph, it is clear that when interest rates are at the maxim, the inflation rate is at the minimum and vice versa.

Summary and Conclusion

Interest rates have an inverse relationship with inflation; when the interest rates are high, inflation reduces, and inflation arises when the interest rates are low. When the interest rates are high, many people borrow loans because they will pay less and they will have a high disposable income. Consumers' spending increases, which creates a mismatch between available goods and the quantity demanded. To attain equilibrium, prices go up, implying rising inflation. Low-interest rates also lower the marginal value of money, which implies that a lot of money is required to make a purchase. This directly equates to high prices of goods and services.

When the interest rates are high, few people borrow money, leading to reduces circulation of money in the economy. When the supply of money is low, its marginal value increases, meaning that little money can be used to make great purchases. At this point, the prices of goods and services are low. High-interest rates also imply that consumers' spending power reduces, causing a reduction in demand for goods and services relative to supply. To attain equilibrium, prices are reduced so that consumers can make more purchases. Businesses may also respond to high-interest rates by laying off some employees, which further reduce consumer spending, calling for a reduction in prices.

The Federal System should watch variables such as consumer price index and producer price index to maintain manageable inflation. When these indicators rise more than a manageable rate, the Federal system will increase the interest rate to minimize spending and put prices under control. When the indicators reduce so much, the system should also reduce the interest rates to control prices.

References

Ahiakpor, J. C. (2019). Macroeconomics Without the Errors of Keynes: The Quantity Theory of Money, Saving, and Policy. Routledge.

Borio, C. E., & Hofmann, B. (2017). Is monetary policy less effective when interest rates are persistently low?

Brown, S. (2020). Global inflation remains stubbornly low as asset prices buck the trend-interest rates. finweek, 2020(4), 25-25.

Geetha, C., Mohidin, R., Chandran, V. V., & Chong, V. (2011). The relationship between inflation Growth in Nigeria. The Empirical Economics Letters, 1100-1115.

Günel, T. Asymmetric Effects of Inflation Volatility on Economic Growth in Turkey: New Evidence Based on the NARDL Approach.

Kiley, M. T., & Roberts, J. M. (2017). Monetary policy in a low-interest rate world. Brookings Papers on Economic Activity, 2017(1), 317-396.

RT Ferreira, T., & Shousha, S. (2021). Supply of Sovereign Safe Assets and Global Interest Rates. International Finance Discussion Paper, (1315).