how does raising interest rates fight inflation?


How does raising the interest rates fight inflation? From what I’m seeing in real estate, the higher rates keep home prices low(er) than they could go. Is that why? But what about car loans? Help!

(No politics please)

In: 2


Remember that “inflation” applies to the money supply in general, so any analysis of it should not be restricted to specific markets such as the real estate or car loan markets.

Banks earn money by lending deposits and collecting interest.

The safest borrower is the Federal Reserve because it always makes its payments. The Federal Reserve does not spend the money it borrows on goods or services.

Normal borrowers must pay higher interest rates than the federal reserve because they have a higher risk of missing a payment. Normal borrowers spend the money they borrow on goods and services, like construction, business expansion, real estate, etc.

When the Federal Reserve offers to pay a higher interest rate, normal borrowers must pay an even higher rate. This means normal borrowers can’t afford to borrow as much, so they end up with less money to spend on goods and services. This makes the prices of goods and services go down.

When interest rates are raised, it becomes more expensive (for individuals, companies, banks, basically everyone) to borrow money. It also means that money kept in savings will receive a higher return.

So in a relatively short period of time, a rise in interest rates can get a country to cut down on spending. And if people aren’t buying stuff, prices will stop increasing (i.e. inflation will slow down) due to lack of demand.

No doubt there is a much more complete explanation to it, but hopefully this provides an intuitive understanding of the basic idea.