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How Interest Rates Work

By: Dave Roos  | 

Interest Rates and Inflation

interest rates connection
The connection between interest rates, spending, jobs and demand.
HowStuffWorks

Inflation is the rise over time in the prices of goods and services. 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 should rise at the same rate as prices [source: Investopedia].

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

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  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 and so on. Manufacturers are producing goods at a slower rate than people are demanding goods.
  3. When supply is less than demand, prices go up.

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

  1. For several possible reasons, the cost of doing business starts to go up independent of demand. This could be because labor unions negotiate new contracts 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.

So how do interest rates affect the rise and fall of inflation? As 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. When inflation gets too high, then money has little value because prices are going up so fast. So consumers buy up goods immediately rather than saving money for later, which makes inflation even worse, as there are less goods to buy and more desperation to unload unwanted cash.

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 Fed's target inflation rate is an average of 2 percent over time [source: FRBSF].

Two economists have written that since the 1950s, every time inflation has exceeded 4 percent and unemployment has been below 5 percent, the U.S. has gone into a recession within two years. In April 2022, the inflation rate was 8.5 percent while the unemployment rate was 3.6 percent, which could mean a recession is on the horizon even if the Fed continues raising interest rates [source: Domash and Summers].

Originally Published: Jan 2, 2008

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Sources

  • Curdia, Vasco. "Average Inflation Targeting in the Financial Crisis Recovery." Federal Reserve Bank of San Francisco. Jan. 10, 2022 (May 2, 2022) https://www.frbsf.org/economic-research/publications/economic-letter/2022/january/average-inflation-targeting-in-financial-crisis-recovery
  • Domash, Alex and Summers, Lawrence. "Fed hopes for 'soft landing' for the U.S. economy, but history suggests it won't be able to prevent a recession." The Conversation." May 2, 2022. (May 2, 2022). https://theconversation.com/fed-hopes-for-soft-landing-for-the-us-economy-but-history-suggests-it-wont-be-able-to-prevent-a-recession-182270
  • Federal Reserve. "The Discount Window and Discount Rate" (May 2, 2022) https://www.federalreserve.gov/monetarypolicy/discountrate.htm
  • Federal Reserve Bank of San Francisco. "What is the difference between the real interest rate and the nominal interest rate?" (May 2, 2022) https://www.frbsf.org/education/publications/doctor-econ/2003/august/real-nominal-interest-rate/
  • Federal Reserve Bank of San Francisco. "What are the tools of US monetary policy?" (May 2, 2022) https://www.frbsf.org/education/teacher-resources/us-monetary-policy-introduction/tools/
  • Federal Reserve Education. "The Structure and Functions of the Federal Reserve System" (May 2, 2022) https://www.federalreserveeducation.org/about-the-fed/structure-and-functions
  • Federal Reserve Education. "Monetary Policy Basics" (May 2, 2022) https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy
  • Fernando, Jason. "Inflation." Investopedia. Jan. 12, 2022 (May 2, 2022) https://www.investopedia.com/terms/i/inflation.asp
  • Heakal, Reem. "Forces That Cause Changes in Interest Rates." Investopedia. March 28, 2022 (May 2, 2022) https://www.investopedia.com/insights/forces-behind-interest-rates/
  • Hyerczyk, James. "Cost-Push and Demand-Pull Inflation: Definitions and Examples." Nasdaq. June 29, 2021 (May 2, 2022) https://www.nasdaq.com/articles/cost-push-and-demand-pull-inflation%3A-definitions-and-examples-2021-06-29

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