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
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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