Why does interest rate go up when inflation goes up?

Answer 1

While it is true that the government often raises interest to fight inflation, that is only part of the story.

The other part is that when inflation goes up, real interest rates need to rise if they are to stay the same in inflation-adjusted terms. Let's look at a simple example.

Suppose that the inflation rate is 0% and the interest rate on my savings deposit is 5%. If the inflation rate jumps to 8%, then my real (after inflation) rate of return is -3% (5 - 8). I am actually losing money because my savings are shrinking in value. To persuade me to continue putting money in savings, the bank will probably have to raise its interest rate to 13% (8 + 5).

Answer 2

Inflation is due to too rapid growth of the money supply so to slow down the growth the fed raises overnight interest rate to banks to decrease bank borrowing (which is how the money is increased). In the case where the fed policy is not sufficient to stop inflation lenders are no longer willing to loan money long term at low rates because what matters to them is the real return on their funds, so long term rates will rise.

Answer 3

Increased interest rates arent a result of higher inflation they are rather a response to it. When inflation increases in order for the government to reduce its impact in the economy it adopts a contractionary monetary policy which involves increasing interest rates and reducing money supply in an attempt to reduce flow of money in the economy and thus reduce demand by making savings more attractive.

Answer 4

The theory is that if you raise interest rates people won't borrow as much money which means they won't buy as many things. This creates a lack of demand, which lowers prices, which lowers inflation.

Answer 5

If it costs more to borrow money it will discourage spending. (Those monthly car payments mean a civic instead of an accord)

It discourages investment and hiring etc. It slows the rate of economic expansion. (I'll wait 'till next year to put in the new production line and hire more workers.)

It draws money out of the capital market. (If I can get a guaranteed 5% in risk free debt why should I invest in the stock market?)

It's a blunt instrument to more or less keep the economy in balance.

Answer 6

as a brake to inflation