Relationship between inflation and interest rates
Introduction
Predominantly, most economic agents base their decisions on the current and expected changes in the economic conditions. Variations in interest rates have been used as a major variable by most researchers and policy analysts. Additionally, the behavior of interest rates in the economy has been studied since the interest rate is a significant macroeconomic factor to help in the understanding of how it is related to other macroeconomic variables and its impact on the economy. Primarily, interest rates entail the percentage of the loan that lending institutions charge as interest to borrowers, and it is mostly expressed as a proportion of the outstanding loan (Forder, 2014). Interest rates have a significant relationship with various macroeconomic factors, which in individual or combinations set the direction of an economy. One of the macroeconomic factors that are closely related to interest rates is the inflation, which represents a situation in the economy where prices of goods and services are persistently rising (Forder, 2014). In recent years, the relationship between the inflation and interest rates has attracted the attention of many researchers. This paper will examine how inflation relates to the interest rates and how time lag affects spending and saving decisions
Meaning of inflation and interest rates
The majority of investors usually do not have enough funds to put in the desired investments. As such, they turn to the existing lending institutions in the economy to seek financial support. Since these lending institutions are profit oriented, they tend to impose some charges that accompany the repayment of the borrowed funds. In most cases, a given percentage of the borrowed amount is charged to the borrowers. This proportion of the borrowed funds that borrowers pay in addition to the amount borrowed is the interest rates, and it changes depending on the prevailing economic conditions in the economy. Interest rates can be real or nominal. Thus, interest rates can be distinguished on the basis of its measurement in terms of money and goods. Real interest rates entail the returns on loans in terms of an equivalent value of goods while nominal interest rates indicate the returns on loans expressed in monetary terms (Mitchell-Innes, 2006). Inflation is an economic indicator that represents a situation in the economy in which prices of goods and services increase persistently. The inflation rate varies among countries and it usually measured as a percentage price changes from a particular year often referred to as the base year (Mitchell-Innes, 2006). Price indexes are the key indicators of the rate at which prices have been inflated. In most countries, the inflation rate is measured using CPI (consumer price index) and PPI (producer price indexes). CPI measures variations in prices of goods and services from the perspective of the consumer while PPI indicates the average changes in selling prices offered by domestic producers over time (Forder, 2014).
The relationships between inflation and interest rates and how time lag affects spending and consumer decisions
Various economic scholars have demonstrated how inflation is related to interest rates. Additionally, researchers have studied both the short-term and long-term impacts of both changes in interest rates and inflation on the economy, particularly on savings and investment decisions. Inflation is an undesirable phenomenon that results from the interplay of various factors and economic policies. The established central monetary institutions in different countries develop monetary policies that mainly focus on economic management through the control of the levels of money circulation and borrowing in the economy. Most of the monetary policies implemented in any economy are intended to control inflation to prevent the occurrence of economic downturns. Inflation and interest rates are related in various ways.
Asgharpur, Kohnehshahri, and Karami (2007) found that inflation and interest rates management are some of the main ways that the government uses to manage the economy. The causes of inflation are highly correlated with changes in the interest rates. The level of interest rates is often determined by the demand for loans, which can be influenced by the decisions of various economic agents. The levels of property ownership in the economy and the size of GDP also have significant effects on the interest rates. Inflationary situations occur as a result of disequilibrium in the markets (Asgharpur, Kohnehshahri, and Karami, 2007). The type of the market structure can therefore be an important factor in the understanding of how inflation and interest rates are related. In markets where producers have greater control of prices, changes in the monetary policies such as bank rates may not have significant impacts on the market prices. However, in market structures such as perfect competition, a change in monetary policy will have fundamental impacts on the prices.
Interest rates affect the capacity of individuals to borrow money. High- interest rates reduce the borrowing capacity of different economic agents, resulting in the decline in the amount of money that people have for spending. Additionally, high- interest rates affect the investment demand and the prices of various investments. For example, when banks rates are high, individuals tend to refrain from borrowing. As a result, they have constrained budgets and the level of consumption reduces. The demand for consumables as well as investment decreases due to reduced expenditures. Producers lower their production. The demand for labor reduces due to reduced production activities. The ultimate result of these events is the falling product and services prices as producers try to induce demand. Thus, high -interest rates tend to reduce the inflation rate in an economy. When the inflation rate is high, the government may raise the lending rates to discourage borrowing. This reduces the amount of money circulating in the economy, resulting in falling prices due to the decline in the aggregate demand.
Increases in the rate of interests have major effects on the people’s demand for money. According to Forder (2014), individuals tend to speculate a fall in interest rates when they are high in the current time. During this time, the transaction demand is higher that speculative demand since people have limited funds at disposal to spend on investments. The demand for consumer goods reduces and the markets have to establish new equilibriums. Producers reduce their selling prices to attract demand. The overall effect is the occurrence of deflationary gaps since people have limited funds to purchase the existing goods and services in the markets.
Low- interest rates have opposite effects on inflation with high- interest rates. One o f the main effects of lowering the interest rates is that it encourages money borrowing. Low- interest rates tend to attract many borrowers. This is the main basis of competition in the financial sector where different financial institutions charge competitive rates to increase the number of borrowers. When interest rates are low, people borrow large sums of money. As a result, the amount of money circulating in the economy tends to increase. Consequently, the demand for different products increases as the rate of transactions increases. The suppliers increase the prices of the products and services due to increased demand. Additionally, the level of demand for consumer goods increases beyond the supply, resulting in market disequilibrium that produces inflationary gaps. The excess demand for products and services triggers the price increase, resulting in demand-pull type of price inflation. The government usually intervenes to correct this situation by initiating policies that help to reduce money in the circulation. It conducts the sale of bonds to reduce the amount of money held by the public. The central monetary institutions may also increase their lending rates to other banks to reduce the level of borrowing.
Reductions in interest rates have significant effects on the saving capacities of individuals (Mitchell-Innes, 2006). When the banks lower their interest rates on deposits, people are discouraged to save. Since the disposable income is either saved or consumed, the level of consumption will increases. Consequently, the demand for consumer goods will increase leading to increased inflation. The high demand for various products coupled with increased profitability to the producers due to increased sales will prompt the producers to expand their production in the anticipation of more profits. As a result, the demand for raw material and labor will also increase, resulting in increased production costs. Consequently, the producers will be forced to increase the prices of the products further to cover the marginal costs.
Low- interest rates tend to fuel both demand pull and the cost- push types of inflation. People refrain from savings due to low interest paid on deposits and increase their borrowing. High level of money supply increases the amount of disposable income among consumers, resulting in increased demand that sparks demand- pull price inflation. On the other hand, high demand results in increased sales that prompt the producers to increase their production volume. Increased production results in high marginal cost as the prices of raw materials and cost of labor increase. Consequently, the producers end up raising their prices to maintain their target profit level. When the interest rates are low, people do not expect them to reduce further. They speculate increase in interest rates since the government must respond to the impacts of falling interest rates. Some people may decide to invest in assets such as real estate instead of depositing their money in banks. Furthermore, the level of investment may increase for other assets when the bank rates are poor. Rising demand for assets encourages the sellers to increase prices due to potential profitability. Additionally, low- interest rates on loans tend to attract international investors, which increase the demand for investment pulling up their prices.
Conclusion
It is undeniable that inflation and interest rates are related. An understanding of how the two macroeconomic variables are related is vital to help in studying the behavior of the economy and how various economic agents respond to changes in both inflation and interest rates. Inflation affects consumer spending by reducing their real income.
Various economic theories have demonstrated how changes in interest rates produce different levels of inflation and the policy instruments that the government adopts correct the situation. High- interest rates affects inflation by discouraging borrowing and encouraging people to deposit more money in banks, which results in reduced aggregate demand and falling prices as producers try to induce demand. Comparatively, low- interest rates encourage borrowing, resulting in increased money in the economy that sparks price inflation.
In summary, the correlation between interest rates and inflation can be investigated by considering various effects that changes in interest rates and inflation have on the behavior of the economy.
Bibliography
Asgharpur, H., Kohnehshahri, L.A. and Karami, A., 2007. The relationships between interest rates and inflation changes: An analysis of long-term interest rate dynamics in developing countries.
Forder, J. 2014. Macroeconomics and the Phillips curve myth. United Kingdom: Oxford University Press.
Mitchell-Innes, H.A., 2006. The Relationship between interest rates and inflation in South Africa: Revisiting Fishers Hypothesis. Masters of Commerce, Rhodes University.
