Friday, January 09, 2004
Inflation and interest rates
Posted by David Smith at 09:36 AM
Category: Q & A Forum

Q. Could you provide a brief idiot's guide to inflation and interest rates and the relationship between them? How does raising interest rates reduce inflation? - Yuba Bessaoud, London.

A. Inflation is the rate of increase in the general price level, so a 10% inflation rate means prices overall are 10% higher than a year ago. Interest rates are the cost of borrowing, or the price of money. A 10% interest rate is the return a saver will get, or the amount a borrwer will have to pay, over a year. There are many ways of thinking about the link between interest rates and inflation. The easiest is the one used by the Bank of England.

When economic growth is strong, and in particular when spare capacity has been used up - economists say the output gap has been closed - there will be pressure for higher inflation. One example would be that when unemployment is low, additional demand for labour will tend to push up the growth in wages.

Interest rates are therefore used to keep growth broadly in line with its long-run trend of 2.5% or so each year. Higher interest rates discourage borrowing and encourage saving and will tend to slow the economy. Lower rates encourage borrowing and have the opposite effect. There are other ways interest rates affect growth and therefore inflation, summarised in this useful paper from the Bank of England.


I hear that the BOE is adopting a hedonic adjustment to the inflation measure (RPI) as of this month onwards, where anything that is improved costs less than it actaully does. Perhaps the RPI measure of inflation which has stood for 40 years at 3% will then match the CPI measure of inflation at 1.6%?

What are the longer term consequences when interest rates are kept below real inflation?

Posted by: Dr AJ Hammond at March 23, 2005 01:30 PM

The ONS, which compiles the consumer prices index, is using hedonic techniques for two components of the CPI - laptop computers and mobile phones, as of now. This is an attempt to quality adjust prices for these items, where technology is changing fast. The ONS says the application of such techniques to other products will be on a case by case basis, so the impact on CPI inflation is likely to be small.

On your other point, the result of keeping interest rates below inflation would, after a time, be excessive growth in demand and, in consequence, significantly higher inflation. That is why economists tend to talk about a neutral or natural real interest rate (i.e. above inflation) of 2 or 3 per cent.

Posted by: David Smith at March 23, 2005 08:14 PM

The last paragraph wasn't too clear. You mean that the economy's pace = inflation = percentage change in price of commodity from one year ago ?

So far the relationship from your last paragraph is: high interest rates = slow down economy and low interest rates will do the opposite.


Posted by: Tasha at May 15, 2007 09:50 AM

I doubt if the guy has a real understanding of the relationship between inflation and interest rates.
In UK, the government is lowering the interest rate to prevent high inflation.
In China, the government is increasing the interest rate to control high inflation.
In the news, its always interest rate has increased as a result of higher inflation, or interest rate has droped as a result of higher inflation, both are just the same way to say "inflation increased, interest rate changed".

Posted by: Dave at April 4, 2008 01:20 PM

Once the interest rates are hiked, the cost of the goods sold would increase due to increase in finance charges thus resulting in inflation. On the other hand by increasing the interest rates, the economic growth is made to slow down as hyper growth results in inflation. Since Inflation is a result of excess money in the system, the interest rates should ideally fall due to excess supply. Very confusing :( PLease help to understand

Posted by: Muralidhar Barkur at June 25, 2008 10:40 AM

very confusing indeed. In my country, interest rates have fallen sharply over the last 4-5 years and guess what, so has the inflation rate. Makes me wonder whether economics makes any sense at all! The explanations for an inverse relationship between the two make sense, but it's just not what we see happening. What's the reason for that?

Posted by: mutemba at August 13, 2008 01:33 PM

You must always remember that there are long and short term effects to inflation. Issues caused by changing interest rates are really being highlighted at the moment, there is more than one way to look at it.

Everyone knows aggregate demand: C + I + G + (X - M)

Up interest rates =
-Down consumption
-Down investment

Downward pressure on aggregate demand causes less inflationary pressure and also unemployment.

Less investment causes a long run shortage in capital stock unless of course investors source their assets in other countries - which could lead to increases current account balance (decrease in foreign direct investment for our nation)

So in the short term we could say that AD decreases - less inflation
But in the long run, there would be less growth in productive capacity.

At the moment in the UK, the financial crisis has led to cashflow problems between big lenders. To ease cashflow, interest rates are lowered - despite 4.7% inflation. Interest rates are not just used for inflation.

Posted by: Alex Tupper at September 26, 2008 12:40 PM

Inflation is NOT equivalent to price increases. Inflation is an increase in the money supply. Price increases are a result of this, therefore, Inflation causes price increases.

Among other things, inflation causes devaluation of currency, which in turn increases interest rates to recoup devaluation losses.

At least that's how I interpret it.

Posted by: Clarence Yu at January 5, 2009 03:37 PM

I am an A level economics student. we are studying about inflation and interest rate, this site has been a fantastic help! Thank you all so much!

Posted by: Perciville Craig-Danielson at January 20, 2009 11:55 AM

i don't understnd one thing,in my country the concept is that lower interest rate leads to higher inflation as borrowings become cheaper and people start borrowing more of houses cars etc,as a result demand outsrips supply,but how is it not possible the other way round,i mean borrowings are generally made by big corporates which are basically manufacturers of diffrent products and this should itself lead to more of production i.e. more of supply which will ultimately lead to demand supply equilibrium.

Posted by: nupur rastogi at December 31, 2009 04:05 PM