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

Question

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.

In: 1

Answer 1

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.