Q & A Forum Archives
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.