Interest Rates Vs. Inflation

These days we see news headline telling us central banks has increased interest rates to control current inflation. So how does this process help reduce inflation?

Interest Rates

In the simplest of terms, interest rates are the price you pay for borrowing money. We usually borrow money in the form of credit cards, mortgages, business loans or student loans. After some time, we must pay back what we borrowed plus a percentage of the original loan, this added percentage is what we refer to as Interest Rate.

Interest rates can be of two type, Fixed or Variable. As the names imply, fixed rates never change and variable change depending on external factors such as time and the macro-economy.

Generally, when interest rates are high, it would be more expensive to borrow money and when interest rates are low, it would be less expensive to borrow money.

Inflation

Inflation is the decrease in the purchasing power of money. We can simply see it as the general increase in the prices of goods and services in our lives or rise of cost of living.

Interest Rates Vs. Inflation

Inflation occurs when there is too much money in circulation but there are only fewer goods or services to purchase. When people have a lot of cash and doesn't have much to spend it on, they bid up the prices of goods and services, resulting in rise of living cost.

This is where central banks come in and increase interest rates. When interest rates are high, people will rethink borrowing money or using credit cards ultimately biding down prices of goods and services.

High interest rates slow down people's spending and increase the purchasing power of money which reduces inflation.

Final Thoughts

High interest rates do provide a solution for inflation but they also have their downside. High interest rates can cause economic growth to slowdown, as a result people might lose their jobs. Economic slowdown can also lead to recession. Furthermore, Crypto price and stock price will fall. Therefore, increasing interest rate have to be balanced between reducing inflation and its long term economic impacts.

Disclaimer

I am not a financial advisor. The information found here are for educational purposes and cite my personal opinion.

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