what is the relation of inflation and Interest rate in the economy?

Question

liquidity effect and impact on Stock market

Answer 1

This based on the Australian economic system.

Inflation is the change in the general level of retail prices as measured by the Consumer Price Index (CPI). Inflation is measured as a percentage based on the change in price of a range of goods and services.

Interest rates are effectively the price or value of money. The Reserve Bank Of Australia (RBA) sets short-term interest rates in the money market. This is the interest rate which banks recieve on money which they invest overnight. When the interest rate that the banks recieve changes, the banks usually follow-on and that interest rate becomes the basis of the interst rates that they offer their customers.


If interest rates are low, consumers tend to spend more money, as less of their money is used to pay off home loans, credit cards etc. As consumers are buying more goods and services, business must produce more goods and services. Businesses borrow to purchase/build extra plant to keep up with the increased demand. As business sells more goods and services, their profits increase thus pushing their share prices higher.

As demand for goods and services by the consumer continues, business hires more staff to keep up in production. When the economy reaches full employment (i.e. theres no one else business can hire) a shortage of goods and services becomes apparent. Under the rules of supply and demand, the cost of goods and services rises. The cost of living (i.e. inflation) increases and employes begin demanding higher wages. If this continues, the economy will overheat and fall into a recession.

This is where the RBA gets involved. The RBA controls the economy through interest rates. In order to slow the economy down and stop it over heating, the RBA lifts interest rates. This causes higher loan and credit repayments for consumers and forces them to spend less money. It effectively increases the value of money and limits the amount of money in the economy. This is known as a tightening of monetary policy. It reduces the amount of money available by consumers and companies to put towards investments, as more people save any excess money due to growing uncertainty about the future. This means that people are investing less money in shares, so there will be more shares available, with nobody purchasing them, which drives share prices lower.

As consumer demand decreases, a lower demand for goods and services prevails. Prices for goods and services stabilise.

Interest rates and inflation also affect the profits (and therefore the share price) of companies trading internationally. Interest rates and inflation affect the price that is paid for imports and exports, and affect the willingness of other countries to trade with Australia.

This would be similar in other world markets.

Cheers

Answer 2

Inflation means rising prices of all goods and services in an economy. It simply denotes that more money is chasing the goods and services. More demand coupled with higher prices and comparatively less supply. As a result, prices keep on increasing.
To check the inflationary trends, the central bank of a nation try to cut the supply of money either by discretionary or by non-discretionary methods. Interest rate changes is the most visible and most affecting method. Most of the times interest rate is raised and sectoral allocations are re-cast by the central bank. Hence it costs more to get money. Hence the liquidity is less.

Since money liquidity is less and at a higher cost, if you deploy this money in stock market, you must try to get comparatively higher returns from the investments. Which is not possible all the time. Stock market is a topsy-turvy thing and may not return you proper profits. Secondly, less money everywhere means the business and industry also suffers resulting in less profits. Less profits means prices of shares going down in the stock markets.

I hope that this short clarification is useful to you. This is purely and economic science angle.

Answer 3

Inflation and interest rate rises together cause uncertainity of people investment of money. Stock and bond market price will fall due to high interest rate. Due to the eletronic trading over the internet, the liquidity effect might be quick and not be affected so much.

Answer 4

Inflation implies that future dollars are worth less than current dollars. Thus lenders would require more dollars in the future for lending dollars today. This price is the interest rate.

The interest rate impacts the stock market as it creates the implied discount rate which stocks are priced at. As a stock price moves up the implied return it gives moves down. For example if we knew for sure a stock would be prices at $20 next year, if its current price was $10 it would offer a 100% return, if it was priced at $19 it would only offer a 5.2% return. Thus as interest rates rise, stock prices drop as people sell stock to invest their funds in other high interest yielding assets.

Answer 5

During periods of high inflation rates, which is described as a period where there's too much money in circulation resulting in high demands for goods and services which will drive up its prices (low supply -high demand), Central Banks counter this unpleasant situation (of high prices) by increasing interest rates on lending money so that money circulation is slowed down i.e. , not many people will borrow money due to high interest rates. No new money will go into circulation since bank lending will be down.

Answer 6

The interest rate has to contain a rational return on the investment, as well as compensating the lender for the loss of value due to inflation during the term of the loan.

Answer 7

I will show you the implication diagram,
Higher inflation==>Higher employment or lower unemployment==>Higher price level==>Higher inflation==>higher interest rates==>investors switching from bonds to stock for fear of loss in value==>higher demand for stocks due to switching effect and due to expectation==>higher stock prices==>higer stock indices.

where ==> indicates implies.