Please explain how higher interest rates helps reduce inflation? No matter what, people still have to buy shit. So how does high interest rates get people to spend less? People still need to buy homes, cars, food regardless of what the interest rate is. Those are kind of necessities, so shouldn’t the government do more to make it more affordable?
And if businesses are paying more for a product, then they have to charge the customer more. They can’t charge less just because people aren’t buying. If they do they won’t make any money themselves.
I’m confused. Please explain it to me.
In: Economics
Money spent buying bonds is effectively taking money out of circulation temporarily.
When businesses can’t get cheap loans they become more stringent with their budgets
No – price controls have never worked for the benefit of the general public
Economies are very complex; too much of a push in any direction will make things a lot worse
Did you bother to search this before asking?
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byu/iiscreative from discussion
inexplainlikeimfive
High interest rates means two things:
* It costs more to borrow in terms of interest accrued.
* You get more interest on your savings.
Both together work to disincentivize spending, meaning it doesn’t make as much sense for businesses to increase prices as much, so inflation rate is reduced (remember, reduction in inflation just means reduction in inflation rate generally, meaning price increases from inflation grows slower).
At least, that’s the logic of it. Reality didn’t work out that way as cleanly.
Inflation, generally, is caused by increased demand for goods and services. Generally, as people have more money they will spend that money on goods and services, so that pushes up the demand
Low interest rates serve to increase the availability of money, because it’s cheap to borrow. People borrow money to buy bigger/nicer houses. People borrow money to buy cars. Crucially, governments borrow money to spend on services. This all filters into the economy through wages to workers and income to business owners, and THEY spend more because they are making more, and that causes prices to go up as demand has gone up
On the flip side, raising interest rates makes borrowing money more expensive. It kind of soaks up the excess money, so people have less to spend on goods and services because it’s now going into interest payments, and they can borrow less because they can’t afford the payments. People buy fewer cars, they buy fewer and cheaper houses, they borrow less for renovation projects. Crucially, more government money goes towards interest instead of to services or payments to citizens so that money doesn’t filter into the economy
Basically, inflation is caused by money pumping into the economy. Higher interest rates are like a sponge that soaks up that excess money
>People still need to buy homes, cars, food regardless of what the interest rate is.
Lots of people do, sure. But there’s a huge demand for homes, cars, and food that people can otherwise go without for the time being. (less so for food, of course)
Like I have a perfectly good car, literally zero problems with it at all. I still kinda wanna get a new one though, but because interest rates on loans are higher now I decided to not do that. That reduces the demand for cars by one, and I know I’m not the only person that did that.
The value of a dollar in the modern economy is based on circular reasoning. At the end of the year, the government measures how many dollars were exchanged and how many goods and services were rendered. If the country only made milk and it made 10 gallons of milk and $10 was exchanged the entire year, each dollar can buy a gallon of milk. If everyone suddenly got a $10 check from the government but milk production stayed constant, some people might want to buy more milk with the extra money they have, but the problem is the milk supply remains the same while demand is increasing. Some people might be willing to pay more for milk, which drives up the price of milk to a new equilibrium where the price is high enough that all the milk gets purchased at the same rate at which it’s produced.
The economy is experiencing inflation; one solution would be to build more production capacity so there is no longer a milk shortage. The government is not in the business of making milk; if investors want to capitalize on the milk shortage, they can start a dairy. The other solution is to slow down the rate at which money is spent which reduces demand. Raising interest rates encourages people to put more money in savings and not spend it, but more importantly, it discourages people from borrowing money because it is more expensive. Fewer people borrowing money means there are fewer dollars flowing in the economy and as long as those fewer dollars isn’t also associated with lower production of everything, inflation is decreasing.
I’m an ex banker and currently work for the Fed. So let me explain it because most people get it wrong.
It’s not because businesses take out less loans. (Although they do)
It’s not because demand decreases. (Although it does)
The reason inflation lowers with high interest rates is because when interest rates are low, it pays more for banks to borrow from the fed. This increases the money supply.
Just like you when you’re looking at interest rates. The banks can either spend money marketing to new consumers etc, or they can borrow the money and pay the nominal interest rate. No marketing needed. The latter is always easier. So they are incentivized to do this.
When interest rates are high, it pays the banks more to lend money to the fed. Why lend to risky people when the fed is paying 10% for instance. They are incentivized to send their (your) money to the fed where it draws more interest with less risk than in the private sector.
When they lend money to the fed it is taken out of circulation. The fed just holds it on their books. (Because this is their entire purpose)
The rest of the stuff like less demand etc is down stream from this.
Think about it the other way around:
You need to buy a house/car.
Interest rates go down, so you’re willing to borrow a little more to buy the house/car you want. The price for the same thing went up.
If you don’t borrow more, someone else will and you’ll lose the house/car to them.
What happens if you decide to buy a cheaper house or car? Well guess what, the same thing happened to those houses/cars and now they cost as much as the house/car you originally wanted. All the prices have gone up; there was inflation.
Lowering interest rates prevents that. Plus the other things people are mentioning.
I think you’re overestimating how much people NEED to spend. Unless you’re homeless, you don’t NEED to buy a new house (or if you do, you don’t NEED to build a brand new house on the outskirts of town necessitating new roads, pipes, electrical girdwork, etc) when you can buy an existing house for cheaper. You don’t NEED to buy a brand new Tesla when an older model would be much cheaper. You don’t NEED to buy new clothes, new hair products, new tvs, new furniture, etc.
Our economy is based on massive overspending and over consumption. Higher interest rates discourage people from engaging in unnecessary spending. If you’re going to pay a lot more for something today than you might spend in the future, you will probably put off that purchase unless you’re in dire need of it.
Higher interest rates shouldn’t affect the stuff we need to survive like food, etc. because most people are not taking out hundreds of thousands of dollars in loans for weekly groceries.
And yes, businesses can charge less when people aren’t buying. It’s called supply and demand. Part of what you’re paying when you buy anything is just pure profit. You’re not only paying for the cost of the inputs and overhead. If a company isn’t selling any of product A, then they aren’t making any profit at all. Dropping the price and reducing the profit, and making less profit per unit but still making SOME profit, is better than making zero profit at all if no units are moving.
Much more complete answers here already, but the simplest answer is that the interest rate that the Fed sets isn’t about you buying food, or even a car. It’s about the large-scale investments that entire businesses fund by borrowing money. These are loans and investments that happen at a scale far above the individual consumer.
Home loans are (pretty much) the only individual-scale thing that the interest rate affects, unless I’m grossly underestimating how much money the American public has invested in total car loans.
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