Inflation and Interest Rates

Inflation and Interest Rates

You will learn about the following concepts

  • Inflation and interest rates in general
  • Fisher effect
  • Federal Open Market Committee and its policy
  • Effects of high inflation
  • What is deflation?
  • and more

Inflation and interest rates are in close relation to each other, and frequently referenced together in economics. Inflation refers to the rate at which prices for goods and services rise. Interest rate means the amount of interest paid by a borrower to a lender, and is set by central banks.

To clarify what interest rates are, lets pretend you deposit money into a bank. The bank uses your money to give loans to other customers. In return for the use of your money, the bank pays you interest. Similarly, when you purchase something with a credit card, you pay the credit card company interest for using the money that paid for your purchase. In general, interest is money that a borrower pays a lender for the right to use the money. The interest rate is the percentage of the total due that is paid by the borrower to the lender.

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pencilSince we also talk about inflation, a good example could be the following situation. Lets say the overall price level of products offered in a market increased by 3% during the past 12 months. If a household spent $1,000 during the first month for all household expenses, then they must budget $1,030 during the last month for exactly the same quantity of goods and services. Prices of individual items may have increased at different rates and some prices may have even declined, but overall they must budget about $30 more per month now. If their income after taxes does not increase by that amount, they must save less, substitute less expensive items, or incur debt.

Understanding the relationship between money, inflation and interest rates, requires grasping the difference between the nominal and the real interest rate. The nominal interest rate is the one offered by your local bank. For example, if you have a savings account, the nominal interest rate shows how fast the amount of money in your account will increase over time. On the other hand, the real interest rate corrects the nominal rate for the effect of inflation, thus showing you how much the purchasing power of your savings account will rise over time.

Fisher effect

Fisher effectIrving Fisher proposed that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher Effect is shown by this equation: r = i − π. This means, the real interest rate (r) equals the nominal interest rate (i) minus rate of inflation (π). So if your bank account pays you 3% a year in interest on your deposits, but inflation over the next year increases the price level by 1%, then although you have 3% more dollars a year from now, you only have 2% more purchasing power.

From the Fisher equation, you can see that if the real interest rate is held constant, an increase in the inflation rate must be accompanied by an equal increase in the nominal interest rate. The Fisher Effect is an evidence that purely monetary developments will have no effect on the countrys relative prices in the long run. In the short run, the Fisher Effect does not necessarily hold since the nominal rate might need time to adjust if the inflation was unexpected.