How Interest Rates Work

By: Dave Roos

Interest Rates and Inflation

Inflation is the rise over time in the prices of goods and services [source:]. It's usually measured as an annual percentage, just like interest rates. Most people automatically think of inflation as a bad thing, but that's not necessarily the case. Inflation is the natural byproduct of a robust, growing economy. No inflation, or deflation (the lowering of prices), is actually a much worse economic indicator. Also, in a healthy economy, wages rise at the same rate as prices.

A standard explanation for the cause of inflation is "too much money chasing too few goods" [source: Bank of Biz/ed]. This is also called the demand-pull theory. Here's how it works:


  1. For several possible reasons, more money is being spent than normal. This could be because interest rates are low and people are borrowing more. Or perhaps the government is spending a lot on defense contracts during a war.
  2. There's not enough supply to keep up with the rising demand for homes, cars, tanks, missiles, et cetera. Manufacturers are producing goods at a slower rate than people are demanding goods.
  3. When supply is less than demand, prices go up.

[source: Bank of Biz/ed]

Another explanation for inflation is the cost-push theory. Here's how that works:

  1. For several possible reasons, the cost of doing business starts to go up independent of demand. This could be because labor unions negotiated a new contract for higher wages, the local currency loses value and the cost of exporting foreign goods goes up, or new taxes have put a strain on the bottom line.
  2. It's called cost-push inflation because the rise in the cost of doing business pushes the price of products up.

[source: Bank of Biz/ed]

So how do interest rates affect the rise and fall of inflation? Like we said earlier, lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation. If the Fed decides that the economy is growing too fast-that demand will greatly outpace supply-then it can raise interest rates, slowing the amount of cash entering the economy.

It's the Fed's responsibility to closely monitor inflation indicators like the Consumer Price Index (CPI) and the Producer Price Indexes (PPI) and do its best to keep the economy in balance. There must be enough economic growth to keep wages up and unemployment low, but not too much growth that it leads to dangerously high inflation. The target inflation rate is somewhere between two and three percent per year.

For more information about interest rates and related topics, see the links below.

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