Hello, Can someone please briefly explain the relationship between interest rates and inflation? I originally thought inflation and interest rates were inversely related, but now I’m reconsidering that… can anyone help me out? Thanks!
Inflation and Interest rates are not inversely related …during inflation ,interest rates are high as the demand for the money would be high then …
Generally speading, in an expansion, interest rates are relatively low. If there is a fear of the economy overheating, then interest rates are raised to ‘cool down’ the economy and decrease aggregate demand (lower consumption and investment expenditure) In a recession, interest rates believed to be too high. Therefore, interest rates are reduced to ‘stimulate’ the economy and boost aggregate demand (increase consumption and investment expenditure)
beatthecfa Wrote: ------------------------------------------------------- > Generally speading, in an expansion, interest > rates are relatively low. If there is a fear of > the economy overheating, then interest rates are > raised to ‘cool down’ the economy and decrease > aggregate demand (lower consumption and investment > expenditure) > > In a recession, interest rates believed to be too > high. Therefore, interest rates are reduced to > ‘stimulate’ the economy and boost aggregate demand > (increase consumption and investment expenditure) I understand the explanation above and what drives interest rates with regards to expansion and recessions… but how does that relate to inflation?
Think about it like this (someone correct me if i am wrong) The fed wants to decrease int rates when we are in an economic recession in order to increase increase lending/spending/agg dem etc. When we are in an economic recession inflation is decreasing. Therefore, when int rates decrease so does inflation. The fed wants to increase int rates during an expansionary phase in order to decrease lending/spending etc. This is done to ensure that the US is not growing at an unsustainable out of control rate. When we are in an expansion, inflation is increasing. Therefore, when interest rates increase so does inflation.
It may be useful to differentiate between… + realized and expected inflation + short and long interest rates + point in time vs. changes (and reactions) over time This helps us understand somewhat ambiguous statements like “When we are in an expansion, inflation is increasing.” I think the author here means realized, not expected, inflation. In general though, when discussing interest rates, people usually are referring to expected inflation. The yield curve is often thought to comprise three additive components: 1. real interest rate – historically, around 2%. reasonably stable. 2. inflation expectations. these can have a term structure. (Any lender needs to be paid back at least the expected inflation rate to come out even.) 3. term (liquidity) premium. By simple arithmetic, as expected inflation rises, so does the yield curve. A rule of thumb is that long interest rates are impact most by changes in expected inflation; short rates are impacted most by Fed changes. When you get into Fed actions, then things change. For example, if expected inflation get too great, then the Fed will increase the short rate even more – to try to choke off expansion.