👨‍🎓 The relationship between interest rates and inflation

14/52 Macro Mornings Education

Dec 02, 2024

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👨‍🎓 This is part of a 52-week series on macroeconomics designed to build your knowledge step by step. Feel free to catch up on previous emails here if you'd like to start from the beginning!

Dear all,

In our last email, we discussed how central banks use interest rates to control inflation and stimulate economic growth. Today, let’s dive deeper into the relationship between interest rates and inflation and how it affects your financial decisions.

The connection between interest rates and inflation is fundamental to understanding the broader economy. Here’s how they interact:

1.     Higher Interest Rates Reduce Inflation: As we discussed earlier, when central banks raise interest rates, it becomes more expensive to borrow money. This discourages consumer spending and business investment, which reduces demand for goods and services. With lower demand, the upward pressure on prices eases, helping to bring down inflation.
For example, if you’re considering taking out a loan to buy a new car, higher interest rates might make you think twice, reducing your demand and contributing to lower overall economic demand.
2.     Lower Interest Rates Can Increase Inflation: Conversely, when interest rates are low, borrowing becomes cheaper. This encourages spending and investment, which increases demand for goods and services. If the economy is near full capacity, this increased demand can push prices higher, leading to inflation.
, if mortgage rates drop, more people might decide to buy homes, increasing demand in the housing market and potentially driving up home prices.
3.     The Balancing Act: Central banks are constantly trying to strike a balance between stimulating economic growth and keeping inflation in check. If they set interest rates too low, inflation can spiral out of control. If they raise rates too high, they risk slowing the economy too much, leading to higher unemployment and possibly a recession.

For individuals, understanding this relationship is crucial for making informed financial decisions. Let’s consider a few practical examples:

Savings: When interest rates are low, the returns on savings accounts and bonds are typically lower, which can make it harder to grow your wealth. In contrast, higher interest rates can lead to better returns on these safe investments.
Investments: Low interest rates often make stocks more attractive, as the returns on bonds and savings accounts are less competitive. However, when interest rates rise, bonds become more appealing, and stocks might suffer as borrowing costs for companies increase, reducing profitability.
Borrowing: Low interest rates are generally a good time to take out loans, whether for a mortgage, car, or business. However, when rates rise, borrowing becomes more expensive, which can impact your decisions about taking on debt.

Understanding how interest rates and inflation interact can help you better navigate the financial landscape, whether you’re saving, investing, or borrowing.

In our next email, we’ll explore what happens when interest rates rise and how you can prepare for it.

Alessandro
Founder of Macro Mornings

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