Increasing interest rates leads to higher inflation so why do it?

Question

It seems to me that putting up the interest rate and therefore mortgage/loan repayments leads to a need for higher wages to pay for these-increasing inflation.

Yes of course, as one or two people have said, it puts new people off borrowing but the present ones and future ones wil merely ask for a wage increase to pay for the higher rates. So inflation continues.

So far most people but not all have missed my main points and addressed other things.

Answer 1

In order to understand how this lowers inflation, it is important to understand how this monetary policy is conducted. When the central bank increases the interest rate, it is not something they just arbitrarily pick and say now here's what you have to pay. In order to accomplish the change in interest rate, they sell government bonds that they are holding to banks, reducing their reserves. Because of the reserve requirement ratio and money multiplier, a $1000 change in reserves can have an impact of $10,000 in the money supply. Thus, when the interest rate is changed, the reserve accounts of many banks are lowered, and thus the money supply is contracted. With less money in the money supply, there is more competition for use of the funds, thus increasing the interest rate. The opposite occurs when the rate is lowered, since the central bank then buys bonds and increases the reserve accounts of banks, thus increasing the money supply.

As far as the higher wage theory goes, this is only partially correct. Yes, workers will ask for higher wages. But they are not that likely to get them on the whole. Remember, the interest rate increased steadily over the past couple of years, increasing a quarter point every six weeks last year. However, individuals did not receive raises nor did they ask for them every six weeks. These higher wages would be incurred by the business, and may or may not be passed on to the consumer. As you would understand, if the interest rates increase and the people have to pay this extra money to their mortgage, they will have less to spend on other goods. If the company increases the price of their goods, the individuals affected by higher interest rates are less likely to purchase these goods. Thus, increasing the price may not necessarily occur, since it may lower the company's revenues in the long run.

Hope this helps.

Answer 2

Increasing interest rates on this occasion were designed as a mechanism to reduce or maintain the current level of inflation. It is hoped it will slow people's spending down - but the big problem is at the top of the tree - the million pound bonuses paid out. When the lucky receivers go out on their property or spending spree they actually push up prices for all of us as there is a trickle down effect from that much disposable cash being put in to the UK economy.

Answer 3

Your wrong, higher interest rates are used to control inflation (well that's what the Fed thinks at least). The theory goes, higher the rates more people will invest or save thus reducing the supply of cash in the market. That's why the Fed increases rates during a bull market because the economy is increasing its supply of cash. More cash higher the prices will become. Feds don't care about those who owe money, they only care about people who invest, and that goes to pretty much anyone in a market economy.

Answer 4

Increasing interest rates can act to lower inflation as it rescricts the money supply. The idea is that too much investment overheats to economy and causes inflation.

House prices are a good example. If everyone can borrow cheaply then more people will be chasing the some houses, which will put house prices up. So raising interest rates cools the housing market.

Answer 5

Increasing interest rate do not lead to higher inflation.

If you are increasing interest rates you are decreasing the money supply.

When the cost of borrowing goes up, companies borrow less money to expand/invest/build factories to produce products

The Fed does this to cool down the economy because it will eventually lead to companies increasing their prices for their goods.

Increase prices for goods is basiclly inflation

So, the feb increases interest rates for the exact reason you said it was bad for them to increase interest rates

Answer 6

Actually, it's the other way around. If the central bank raises interest rates, it makes borrowing more expensive. That, in turn, causes few houses, TVs, cars, etc. to be purchased. This leads to LOWER inflation, since the price of goods will slow.

Answer 7

Inflation [ and de-flation ] is a ratio between productivity and the availability of money. Availability of money is controlled by the government, productivity is a factor in business.

Interest rates is a way to control the availability of money. Inflation is good for governments and bad for businesses and individuals.

Answer 8

I think you are right...the last house I bought I paid cash..not like I am made of money, trust me, but I think a mortgage is such a rip off, even with low interest rates, the amount you actually end up paying is insane!!! I started this a long time ago, bought and paid for a shack...sold it bought a huvel...sold it bought a dump...sold it bought a very modest fixer upper...and so on...each tie I made a bit of money and reivested every penny in the next...it has worked for me...

Answer 9

Inflation is not necessearily bad. In fact small percentage of inflation can be very healthy for the economy.

Answer 10

the marginal proportion of saving (is the proportion of the money you save for each aditional dollar you earn) is a major component to ecourage economic growth according to Solow´s equation, so if you rise interest rates you encourage savings.