Why does the Fed raise the prime rate to combat inflation?


I might also need a quick on inflation as well. All I can think is that they’re trying to de-incentivize interest-based purchasing but I don’t understand how that’s a fix for inflation.

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Whenever a loan is made, effectively neffectively new money is created by making that long. So if you raise the interest rate, you discourage new loans and as a result less new money is made.

A higher prime rate trickles down to higher loan interest rates, which mean that people can’t borrow as much money, which means they have less access to cash. Less cash means you can’t pay as much for stuff, which means the prices of those things go up more slowly.

Well it’s worth understanding what a loan is at it’s most basic. A loan is a way for someone to take something of value but ultimately not spendable (like a home), and convert it into spendable cash. So a loan becomes a way to introduce money into circulation. If we raise the federal interest rate then people will take out less loans. Less loans means less value being converted into spendable cash and introduced into the economy. Less cash being introduced means lower inflation.

A simple view is this:

1. Inflation is when purchasing power goes down.

2. Purchasing power goes down when prices go up but wages do not.

3. Prices go up when demand goes up.

4. To increase loan rates slightly is to decrease the number of new loans slightly.

5. Dropping the number of loans slightly in turn drops demand, because a small threshold of people choose to decline the more expensive loan.

In other words, just to slow down how fast new malls and homes and stuff being built. This is why economists sometimes use the term “overheating” to describe an economy that’s chugging along too fast, you can easily trigger inflation.

Deflation is the opposite of all the above. This happens when the value of your money increases next year compared to this year. “Why build a hospital this year if it will be cheaper to build it next year?”

Inflation is when the value of your money erodes,i.e you have to pay more for goods and services. This could be beacuse of low supply and high demand that increases prices , higher cost that increase prices, or beacuse of increased money supply(lots of money in the economy for g&s whose production is the same. More demand, higher prices).Usually 2 or more of these in combination.

An overlooked driver of inflation is the EXPECTATION OF INFLATION.

When the fed increased rates, it signals a higher cost for loan and credit, so people do not spend as much using credit(credit spending is a very large percentage of total spending).This also decreases investment in speculative investments(stocks, new businesses etc).

This signal from the fed also drives down the expectation of inflation in the future. Pretty soon the economy cools down till the next boom.