how do interest rates and inflation interact with each other in an open economy? What does a change in either mean for the other?
In: Economics
high interest rates attract foreign investors to invest in the country and get a higher return than they would at home. if the country’s currency is floated i.e. subject to market forces then one way central banks can influence the value of the currency is via the interest rate. raising the interest rate will strengthen the currency while reducing it will weaken the currency.
the difference in the domestic inflation rate and the inflation rate in reserve currency countries will also have to be taken into account by the central bank when setting interest rates. if the interest rates don’t compensate foreign investors over and above the inflation rate they will not invest and the currency will weaken.
This is a very, very complicated topic, with many variables. I’ll try to make it as simple as I can and focus on the major interaction, though.
Interest rates are one of the primary determinants of how much people save versus how much they spend/invest. If interest rates are very high, people will want to save more money so they can take advantage of those interest rates. If interest rates are low, there’s less reason to save. If the interest rate was zero, for example, there’d be no obvious advantage from an interest perspective to saving money, and you may as well just use it now.
The inflation rate refers to the speed at which the value of the dollar is falling. While this intuitively seems like a bad thing, a small, steady inflation rate is actually good for the colony in the long term. That’s a little off-topic, though, so let me be more direct. The inflation rate is similar to the interest rate in the sense that it’s a driver of how much people will spend versus save. If inflation is extremely high, people will be more likely to spend now before their money loses significant value. If inflation rates are low—or, far worse, we’re actually having *deflation*, where the value of the individual dollar is going back up—people will be much more likely to hold onto their money.
The two don’t really interact directly, per se, but they are two very important factors in determining consumer spending. Very few things in economics are ever really totally independent, and they all bounce around off each other. That being said, interest rates (the most important ones, anyways) are directly controlled by the Federal Reserve, which is basically our national bank. They may choose to raise or lower those rates based off a trend they see in inflation. But, they can also control inflation to a degree using the interest rates.
I’m not a expert but I get a lot of good info from George Gammon and RealVision on YouTube.
Answer: You can think of inflation as the value of money dropping in relation to the value of *stuff*. One year, a brick costs ten cents, the next year it costs eleven cents, the next year twelve, and so on.
Now, when someone loans money, they charge interest in order to make more money than they gave out- they give you today’s money, and you pay them back with future money. How much inflation is going on determines how much less future money is worth compared to today’s money. If inflation is higher, or is expected to be higher, then interest rates will also go up because the lender will need *even more* future money to get the return they wanted in terms of actual buying power.
They don’t interact that much so you’re making a wrong assumption. However, a low interest rate means it’s cheaper to borrow money, so it can increase the amount of money the banks can create (yes, banks can create money out of thin air). This means more money is floating around and this can increase inflation.
But it doesn’t have to do that, as many other things can impact inflation. For example, the dollar has stayed high in value despite low interest rates because the dollar is a highly valued currency across the world for other reasons.
The central bank (In the USA known simply as “The Fed” controls the money supply, interest rates, etc.
All you have to know is that when the federal reserve RAISES interest rates, they are essentially sucking money out of the economy. While this hurts the economy or slows it down, it does slow down inflation. It’s kind of like a card game. Imagine that you just got ordered to discard all your cards in Magic the Gathering. When they do this, the economy isn’t getting as much money pumped into it. This means that inflation slows down.
When the federal reserve LOWERS interest rates, they are trying to add MORE money into the economy. They can make the economy better, but their may be more inflation!
For example: Nixon LOWERED the rates a lot to boost the economy. It worked, and he was re-elected. Afterwards, a LOT of inflation kicked in and ruined the economy. In response, the fed had to RAISE interest rates (all the way to 21.5%) and then the inflation went away.
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