Interest & Inflation

Interest and inflation rates are at the core of all monetary policy. This piece, while simple, outlines the key principles behind the two.

Interest

Interest is essentially the cost of borrowing, here is what happens when interest rates rise and fall.

Interest Rises

Borrowing is more expensive. You repay the bank more for taking out money. This slows down consumer and business spending which helps cool an overheating economy. This ensures stability keeping inflation in check without triggering a recession.

Interest falls

The opposite. Borrowing is now attractive as it is cheaper. This encourages spending and investment which stimulates economic growth

Inflation

Inflation is the general rise in costs in an economy. I discuss the main three types.

Demand-Pull Inflation

This occurs when aggregate demand grows faster than aggregate supply. Typically,  when economies boom after a downturn.

A booming economy is evident by low unemployment, rising wages, and strong consumer and business confidence. This leads to higher disposable income, meaning people have more money to spend on goods. Hence, businesses experience a surge in demand, with increased orders and growing waiting lists. Supply chains often can’t keep up, since factories can’t instantly expand capacity and raw materials may be limited. This disparity causes prices to rise to ration demand or protect company profit margins. A real-world example of this was the post-COVID boom, where consumer spending on goods spiked while global supply chains remained disrupted.

In response, central banks typically raise interest rates to cool demand and bring inflation under control

Cost-Push Inflation

The cost of producing goods and services increases so businesses pass on the increased costs to consumers.

Input costs may rise due to; higher wages, raw material shortages and supply chain disruptions.

A recent example is the Russia Ukraine war which saw energy prices soar.

This is much harder for the Central Bank to help as they cannot magically produce more oil, however, they may raise rates to prevent knock-on effects.

Imported inflation

This is when the price of imported goods increases potentially due to; rising commodity prices, disruptions to supply chains and currency weakening.

Wage-Price Spiral

1.     Inflation rises

2.     Workers demand higher wages to protect their standard of living

3.     Businesses raise prices to cover increased labour costs

4.     Consumers face rising prices

5.     Workers again ask for higher wages

This is a dangerous process which often requires central banks to raise rates to break this loop before seriously impacting the economy.

I hope this article on the fundamentals of macroeconomics was useful for you. Check out the rest of my work here.