- Recently, the US central bank — routinely called the Federal Reserve — announced that it will raise interest rates by 75 basis points (or 0.75 percentage points).
- The Federal Reserve is doing this to bring down inflation to its target rate of 2%.
What’s in today’s article:
- About Inflation & Interest rates (Meaning, Significance, How it works)
- Relation between the two
- Inflation is basically the general rise in the price of goods and services and the decline in purchasing power of people.
- This means that when inflation rises (without an equivalent rise in your income):
- you are able to buy lesser things than you could buy previously, or
- you have to pay more money for the same stuff now.
- A rising inflation rate implies that the rate (at which the prices rise) itself is increasing.
- In other words, imagine a scenario where the inflation rate was 1% in March, 2% in April and then 4% in May and 7% in June.
- Interest rate is basically a percentage of the principal (the amount you are borrowing) that the lender charges from the borrower for the money lent.
- Not just that, it’s also a fraction of deposits that a depositor gets from an institution (bank or otherwise).
- So, from savings bank interest to interest on loans, these rates are very crucial for the economy.
- Interest rates play a vital role in the economic development of a country, they significantly influence the stock prices and other investment decisions.
Relationship between Inflation and Interest Rates
- Inflation is determined by supply and demand for money according to the Quantity Theory of Money (economic theory defining the relationship between money supply and price of a product).
- Money supply and inflation are directly proportional to each other.
- In simpler words, it means rising money supply in the economy triggers the inflation to rise and declining money supply in the economy leads to a decrease in inflation.
- When the inflation rate fluctuates, the central bank (RBI in case of India) enters into the picture and makes changes in the interest rates to control the inflation.
Role of RBI in controlling inflation:
- During Falling Inflation:
- During falling inflation, RBI lowers the interest rates.
- So, people get less interest on their deposits and are motivated to spend more than saving.
- Plus, lower interest rates incentivise people to borrow more by paying less interest.
- All in all, it triggers consumer spending, and thus, the demand.
- During Rising Inflation:
- As inflation rises much higher because of high demand, RBI will again step up and will increase the interest rates.
- When interest rates will increase, people will save more as they will be getting higher interest on their deposits and businesses will cut their borrowings as the cost of funding will rise for them.
- This, ultimately, will result in decreasing money supply in the economy.
- Again, by the Quantity theory of money, inflation will fall and the problem of higher inflation will be resolved.
- Interest rates drive inflation in the opposite direction. Higher interest rates reduce inflation whereas lower interest rates lead to a rise in inflation.
- The right amount of inflation is good for the economy.
- RBI controls the interest rates via monetary policy using various measures such as reducing/increasing policy rates, conducting open market operations, etc.