Why Do Interest Rates Rise To Control Inflation?

[Jason]

Ok, it's not me asking this question, it was mentioned in the main forum, so though I would start a discussion on why interest rates control inflation.

I'll start with the BBC: http://news.bbc.co.uk/1/hi/business/5242344.stm

[IamSpartacus]

Ok, it's not me asking this question, it was mentioned in the main forum, so though I would start a discussion on why interest rates control inflation.

I'll start with the BBC: http://news.bbc.co.uk/1/hi/business/5242344.stm

Crudely speaking, higher IR makes it more expensive to service existing debts so there's less money around to spend. Less demand keeps prices low (although slows growth).

More subtly, with an independent central bank like the BoE, it is actually interest rate expectations that keep inflation under control. Provided the threat of higher IRs is credible (which today's decision will send a strong signal about) then people will take those future rises into account, borrow and spend less, and keep inflation down without the BoE needing to actually move rates much. Of course, the system isn't perfect and not all inflation is driven by domestic demand so actual interest rate movements are still necessary from time to time.

[dnd]

Here you go....

"Generally speaking, a higher real interest rate reduces the broad money supply"

http://en.wikipedia.org/wiki/Interest_rate

"...inflation is used to refer to an increase in the money supply"

http://en.wikipedia.org/wiki/Inflation

You'll fall asleep by the second paragraphs....

IIRC M3 (money supply in the UK) is running @ 13%....

Edited August 4, 2006 by dnd

[IamSpartacus]

Here you go....

"Generally speaking, a higher real interest rate reduces the broad money supply"

http://en.wikipedia.org/wiki/Interest_rate

"...inflation is used to refer to an increase in the money supply"

http://en.wikipedia.org/wiki/Inflation

You'll fall asleep by the second paragraphs....

IIRC M3 (money supply in the UK) is running @ 13%....

Bloody monetarists...

[AvidFan]

Ok, it's not me asking this question, it was mentioned in the main forum, so though I would start a discussion on why interest rates control inflation.

I'll start with the BBC: http://news.bbc.co.uk/1/hi/business/5242344.stm

Because the cost of borrowing has to be positive, otherwise you get run-away price increases, e.g. HPI in the case of borrowing against that particular asset class.

Generally, reported inflation should be 0.6 * IR as most forms of tax (personal, corporation, etc.) top out at 40%.

AF

[charmer]

Interest rates control inflation via the monetary equation.

MV=PQ.

M is the quantity of money,

V is the velocity circulation of money (how quickly money can flow from one person to another, probably growing slowly, but it;s difficult to tell)

P is the level of prices, so the change in P is inflation.

Q is the quantity of goods produced, the size of the economy or GDP.

This is the model for a simple closed economy (no imports and exports).

So, if we say that both V and Q are qrowing at 2.5% (this is just an assumption as it makes it clearer the actual values are debatable but that's another can of worms) then any % increase in M will increase P by the same % amount to keep the equation level. Happy? Good, so we agree that the growth in the money supply links to inflation?

OK so how do we control the growth in the money supply? Well firstly why does the money supply grow. Essentially it's because the money supply is not determined by how much individuals save or lend. Under this situation growth in the money supply was constrained by the amount saved ( the growth derived from the money multiplier, see Wikipedia, on the role of fractional reserve banking and the money multiplier, I'm sure they will have something on it)

However, this could occasionaly lead to problems and it was decided (this was a worldwide consensus on the role of reserve banks, no consiparcy) that the bank should undertake to provide cash to the system to mainatin stability.

So the bank will lend at the quoted interest rate to retail banks who can then lend on to customers.

{This is not strictly relavent but should help - Therefore the main supply of money comes not from individual savers but from the BoE and the determinant of growth in the money supply will be the relation between demand for loans at the quoted rate, and the rate quoted by the BoE (think Supply and Demand where the price is set, and supply is infinite at any given price). The bank also take deposits, these are the roles of T-bills or Gilts/bonds in the UK which effectively take money out of the system, shrinking the money supply.}

Hence if interest rates at the BoE rise then this makes all loans more expensive slowing borrowing and money growth, and thus inflation.

I hope I haven't made this too basic or patronising. If so I apologise, I am used to explaining this to people with a lesser grasp of economics than many on this forum.

The inimtable

C

[IamSpartacus]

Interest rates control inflation via the monetary equation.

MV=PQ.

M is the quantity of money,

V is the velocity circulation of money (how quickly money can flow from one person to another, probably growing slowly, but it;s difficult to tell)

P is the level of prices, so the change in P is inflation.

Q is the quantity of goods produced, the size of the economy or GDP.

This is the model for a simple closed economy (no imports and exports).

So, if we say that both V and Q are qrowing at 2.5% (this is just an assumption as it makes it clearer the actual values are debatable but that's another can of worms) then any % increase in M will increase P by the same % amount to keep the equation level. Happy? Good, so we agree that the growth in the money supply links to inflation?

OK so how do we control the growth in the money supply? Well firstly why does the money supply grow. Essentially it's because the money supply is not determined by how much individuals save or lend. Under this situation growth in the money supply was constrained by the amount saved ( the growth derived from the money multiplier, see Wikipedia, on the role of fractional reserve banking and the money multiplier, I'm sure they will have something on it)

However, this could occasionaly lead to problems and it was decided (this was a worldwide consensus on the role of reserve banks, no consiparcy) that the bank should undertake to provide cash to the system to mainatin stability.

So the bank will lend at the quoted interest rate to retail banks who can then lend on to customers.

{This is not strictly relavent but should help - Therefore the main supply of money comes not from individual savers but from the BoE and the determinant of growth in the money supply will be the relation between demand for loans at the quoted rate, and the rate quoted by the BoE (think Supply and Demand where the price is set, and supply is infinite at any given price). The bank also take deposits, these are the roles of T-bills or Gilts/bonds in the UK which effectively take money out of the system, shrinking the money supply.}

Hence if interest rates at the BoE rise then this makes all loans more expensive slowing borrowing and money growth, and thus inflation.

I hope I haven't made this too basic or patronising. If so I apologise, I am used to explaining this to people with a lesser grasp of economics than many on this forum.

The inimtable

C

If only it were that simple... I suspect that much of the inflation we'll be seing over the next few months will be driven by oil price rises, a great example of cost push inflation. Of course, if you're a hardcore monetarist you don't believe in this.

[charmer]

If only it were that simple... I suspect that much of the inflation we'll be seing over the next few months will be driven by oil price rises, a great example of cost push inflation. Of course, if you're a hardcore monetarist you don't believe in this.

Hardcore monetarist, you've rumbled me. However, I would argue that your cost push inflation, which I entirely agree is the major threat, would be exogenous to the system. I have limited my explantion basically to a closed system as bringing in outside factors opens a whole new can of worms.

In terms of the real situation rather than just the theory, I reckon that in the long run, if P rises due to exogenous factors then Q, or other factors making up inflation (P) will fall. Basically domestic prices drop, or more likely wages. Either that, or we see a slowdown. However, I reckon this is where house prices could come in, as I believe the equation would consider asset price inflation as part of the inflation issue and therefore the sector most vulnerable to counteract the goods inflation is likely to be asset prices as growth in the money supply will increasingly be channeled towards paying for more expensive goods.

Does this make sense?

C