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
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.
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