How does raising interest rates effect inflation?

Question

When I hear on the news they are raising interest rates to slow the economy and inflation, what do they mean? How does it effect inflation and does inflation ever go down?

Answer 1

Raising interest rates makes borrowing more expensive, both for individuals, and for businesses. Mortgages and lines of credit are more expensive, and companies have to pay more on bonds to issue them.

The net impact of that is that people (and companies) spend less. Spending less means there is less demand for goods and services.

Less demand for goods and services means companies don't hire as many people/work as much overtime etc. There's less pressure in the jobs market, less demand for raw materials, etc. and prices level off, or don't raise as fast as they might have.

By contrast, when the economy is 'overheated', companies are growing 'too' rapidly, trying to meet demand for their goods and services, and end up trying to outbid each other for workers, oil, steel, etc. What does 'too' rapidly mean? It means that the growth rate is not sustainable, and eventually the higher prices would cause a recession.

Government banks attempt to use their influence on interest rates to 'slow the economy' when they think it is overheated, and give it a kick start when it seems 'stalled'. The problem is, it takes 6-18 months for their actions to have their full affect, and they never know what the economy is doing today, only what it did a few months ago (since it takes time for them to collect data). So they are constantly trying to make decisions based on slightly old data about what the economy will be doing 6 months from now, and whether they need to try to adjust it. A rather imperfect science to fine tune. In general levels, however, it works quite well. There have been cases of countries inflation rates well over 40% a year, increasing interest rates rapidly brought them down. That part is fairly easy, its the fine tuning whether you want 2 or 3% inflation a year from now that becomes tricky.

You hear a lot about interest rates because buyers and sellers of stocks are _very_ interested - not just in when the rates change, but in the 'fed' (us federal reserve, who sets gov't interest rates) commentary that suggests what they are planning for the future. Knowing that the Fed is planning to slow down the economy will certainly impact how you expect stocks and bonds to perform.

Answer 2

Inflation will go down if everybody slow down on their spending power. The problem now is that the rising cost of living may not be able to curb with the inflation rate. Hence, inflation rate had increased rapidly these days.

The FED will counter this inflation problem by increasing interest rate. As interest rate went up, the cost of producing will be higher and it will lead the prices of good to be higher. Thus, the consumer will lower down on their spending as the prices of goods and services increased.

Besides that, the interest rate which are higher will actually pull a crowd to save efficiently as it is a good time for doing savings since the interest rate is higher.

However, it may not be a good time to start up a business as the interest is so high which in fact increases the business overhead and running cost.

Please search for more further details in the net. You can try looking at www.wikipedia.org for beginners.