Inflation vs. Interest Rates - Justification

Hello Everyone,

I know as inflation increases so do interest rates increase but need some more explaination on this, as how they are inter-related ?

Think of inflation as a risk premium: the risk of purchasing power loss. So if inflation increases (more accurately, if expected inflation increases), nominal interest rates increase.

Always remember this:

nominal risk-free rate = real risk-free rate + expected inflation rate

required rate of return = nominal risk-free rate + risk premiums (default + liquidity + maturity)

So any risky asset or risk-free asset includes expected inflation as part of the required rate of return of the asset itself, it is like a “risk of purchasing power loss premium” as S2000magician says.

When an economy is overheating (demand is increasing too much compared to an economy’s production capacity), prices tend to increase as well in order to maintain the st0atic equilibrium of the AD/AS model. Central banks maintain a stable inflation rate (2% for the ECB), and they do it through open market operations for example (selling government bonds). By doing so, the interest rates grow (tapering basically), and that is one of the mechanisms explaining why interest rates and inflation rates (cpi) are highly positively correlated.