How can interest rates be used to deal with inflation?


At an annual rate of 8.6% this May , inflation in the United States rose to levels unseen for 41 years. This sharp increase in prices can also be felt all around the globe, with the average price level rising by 9.1% in the UK , 11.3% in Greece and 7.7% in Canada . There are various causes that lead to the acceleration of the inflation rate, mostly supply chain shortages due to the Covid-19 pandemic, increased household demand for goods and services and increased government spending to fuel the economy after the lockdowns.



Inflation rate in the United States, Source: New York Times

(https://www.nytimes.com/2022/05/11/business/economy/april-2022-cpi.html)


It is clear in the above graph that after 2020, with the start of the global pandemic, inflation levels hit a record high for the past 40 years.


With inflation widely considered undesirable, and with the ideal level of inflation estimated around 2%, governments around the globe are taking numerous measures to tackle the increase in the average price level.


A common policy to achieve this is by raising interest rates, in order to decrease total demand in the economy, also referred to as aggregate demand. Interest rates are controlled by Central Banks, like the Federal Reserve (Fed) in the United States, and they are the percentage of the principal (=the amount loaned) that the lenders charge borrowers. By controlling interest rates, governments mostly seek to affect spending made by households (consumption expenditure) and spending by firms (investment).


More specifically, the first group affected by increased interest rates is households. If interest rates are increased, borrowing will now become more expensive, as the percentage of the principal that the households-borrowers will have to pay will increase. This will, most likely, lead to households borrowing less and thus having less money to spend on durables. For example, if a family borrows $100,000 to buy a house, it will have to pay back to the bank $103,000 if the interest rate is 3%, but $2,000 more if interest rates rise by 2%. Thus, some families may think that it isn’t worth it to borrow in order to buy a house, and as a result, total expenditures in the economy will drop, potentially leading to less inflation (decreased prices). The other side to this is that interest rates represent the “reward” for saving in banks, because saving is essentially households lending banks, thus earning interest. Therefore, if interest rates rise, saving will become more attractive, and households will save more and spend less, ultimately leading to a decreased inflation rate.


Similarly, when it comes to firms, which usually borrow to finance capital investments, if the cost of borrowing increases, borrowing and thus spending will fall, leading to lower aggregate demand. Furthermore, if interest rates increase it may be more attractive for firms to save their funds in banks, rather than invest them. Therefore, inflation will decelerate as a result of this decrease in spending by firms.



Core inflation and real interest rates in the United States, Source: Peterson Institute for International Economics (https://www.piie.com/blogs/realtime-economic-issues-watch/why-i-worry-about-inflation-interest-rates-and-unemployment)


Monetary policy in the form of interest rate increases has been applied in multiple economies; in the United States, interest rates are expected to rise to 3.4% by the end of the year, the highest increase since 1994. Similarly, the Bank of England raised interest rates to the highest level in 13 years, 1.25%.

Inflation incurs various risks to economies, and interest rates are a useful tool for central banks to control it. However, it may prove quite challenging for governments to determine the optimal level of interest rates, so as to curb inflation, in a way that doesn’t significantly slow down economic activity and real GDP growth, or doesn’t increase unemployment.


 


References:


“Canada Inflation Rate May 2022 Data - 1915-2021 Historical - June Forecast.” Canada Inflation Rate – May 2022 Data - 1915-2021 Historical - June Forecast, https://tradingeconomics.com/canada/inflation-cpi.


“Greece Inflation Rate May 2022 Data - 1960-2021 Historical - June Forecast.” Greece Inflation Rate – May 2022 Data - 1960-2021 Historical - June Forecast, https://tradingeconomics.com/greece/inflation-cpi.


“United States Inflation Rate May 2022 Data - 1914-2021 Historical - June Forecast.” United States Inflation Rate - May 2022 Data - 1914-2021 Historical - June Forecast, https://tradingeconomics.com/united states/inflation-cpi.





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