So I keep hearing the party line about how it is necessary to increase interest rates in order to contain rising inflation. I just don’t understand it as an explanation? I see that it is an advantage for people with savings and fiscal assets, and in increased liability for anyone with consumer credit debt or a mortgage. Can anyone explain how it helps to curb inflation?
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Increasing interest rates makes it more expensive to borrow money, and more favorable to save money.
In either case, the result is the same – less spending. Makes sense, right?
Since demand-pull inflation is due to demand for goods exceeding supply of goods, anything that decreases spending will help to slow or reduce inflation.
We’re talking about macroeconomic theory here which is very different from things that impact individual activity. So be very careful about applying this to all situations.
Higher interest rates increase the cost of borrowing. As a result, companies and individuals are not going to borrow as much money to fund consumption of all sorts.
1. Companies borrowing less means they are spending less. Things like building materials or office supplies. This immediately causes aggregate demand (average demand for goods and services across the economy) to fall.
2. This means other companies that for example build machines for other companies to also see a slowdown in demand, which causes them to also reduce consumption of things like the metal to build machines.
3. This also impacts the employees of said companies. A company might slow/stop hiring for example to meet the new, lower demand.
Essentially, higher interest rates tend to reduce demand. With market forces, lower demand while holding supply constant means that prices will be pressured to deflate (as in reduce the inflation rate). How much it will deflate depends on the exact situation. For example, if you don’t produce enough food reducing interest rates wont help as much because people still need to eat. But things like graphics cards for your gaming rig are more likely to see reduced demand and eventually lower prices.
Raising interest rates is basically a way to control aggregate demand in an economy. It also has impacts like reducing the amount of money circulating in an economy. Modern economies actually get most of the liquidity/money in the system from things like bank loans.
Oh ok thanks this makes more sense now!
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