Relation Between Inflation & Bank Interest Rates
Inflation is the rise of the overall price of goods in an economy relative to the amount of money in that economy. Credit, like everything else, is a good, so it rises with inflation. However, because of its particular role in an economy it can also effect inflation.
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Cost-Push
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Cost-push inflation is when something such as a new tax or a currency value change raises the cost of goods in an economy. People have less to spend on mortgages, so banks have to raise their interest rates as demand for them decreases.
Demand-Pull
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Demand-pull inflation occurs when more money becomes available to people and they are able to spend more money, which increases demand for--and the price of--goods. If banks lower interest rates, more money is available for consumers, which increases their demand for goods, increasing the cost of those goods.
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Central Bank Cost-Push
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The central bank lends money to other banks and sets its interest rate in an attempt to grow or shrink the economy. If costs are rising, the central bank will try to set a relatively low interest rate to spur demand.
Central Bank Demand-Pull
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If inflation is rising because of demand, the central bank will lend money at a higher rate to try to curtail this demand and keep prices in check.
Striking a Balance
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Economies are too complex to determine the exact rate that will reduce or increase costs or demand as needed. Therefore, the central bank always overshoots it in one direction or another. This is how the central bank's interest rates affect inflation--by trying to stop one kind of inflation, it invariably spurs the other.
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References
- Photo Credit bank image by Pefkos from Fotolia.com
