The Relationship Between Interest Rates and Inflation

The Relationship Between Interest Rates and Inflation

Hailey Low

10 years: Macroeconomist

In this video, Hailey explores the connection between spending, inflation, and interest rates. She explains how increased spending can drive inflation, leading central banks to adjust interest rates and further talks about the two main methods to manage inflation.

In this video, Hailey explores the connection between spending, inflation, and interest rates. She explains how increased spending can drive inflation, leading central banks to adjust interest rates and further talks about the two main methods to manage inflation.

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The Relationship Between Interest Rates and Inflation

8 mins 3 secs

Overview

Inflation and interest rates are intricately connected, with rising inflation typically leading to higher interest rates. Central banks use rate increases to curb inflation, making loans costlier and slowing down spending. Controlling excessive spending involves two strategies: contractionary fiscal policies, such as tax hikes and reduced government spending, and monetary policy adjustments like interest rate hikes. These measures aim to decrease disposable income and manage borrowing costs, respectively. While both approaches have their merits, the choice depends on the economic context, urgency, and policy goals, balancing immediate impacts with long-term financial stability.

Key learning objectives:

  • Understand the link between spending and inflation

  • Understand the various ways through which inflation can be managed

  • Understand the link between inflation and interest rates and how interest rates can be used to influence inflation

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Summary
What is the link between spending, inflation and interest rates? 
Spending increases can lead to inflation, as heightened demand for goods and services tends to push prices up. In turn, central banks often respond to rising inflation by increasing interest rates. Higher interest rates make borrowing more expensive, which can temper spending and investment, thereby slowing down the economy and reducing inflation. This relationship is particularly evident during economic fluctuations, where adjustments in interest rates are a key tool for managing inflationary pressures.

What are the two ways through which inflation can be managed, and which is preferred?
Inflation can be managed through two primary approaches: contractionary fiscal policies and monetary policy adjustments. Contractionary fiscal policies, such as tax increases and reductions in government spending, directly curb spending. Monetary policy adjustments, like increasing interest rates, manage the cost of borrowing. Keynes's perspective suggests a preference for the latter, as it indirectly influences economic behaviour without directly reducing disposable income, presenting a more equitable approach. However, the choice often depends on the specific economic situation and policy objectives.

How can interest rates be used to manage inflation?
Interest rates are a crucial tool for managing inflation. Central banks increase interest rates to make borrowing more expensive, which reduces consumption and investment by households and firms. This decrease in spending helps to slow down the economy and reduce inflation. Conversely, when inflation is low, central banks may lower interest rates to make borrowing cheaper, encouraging spending and investment to stimulate economic growth and increase inflation to a target level. This balancing act is central to monetary policy's role in stabilising the economy.

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Hailey Low

Hailey Low

Hailey Low, an associate economist at the National Institute of Economic and Social Research, specialises in macroeconomic modelling and forecasting. Her research interests include macroeconomic performance and policies, monetary policies, international trade and development, and the interplay between the financial and economic worlds. Prior to joining NIESR, she earned a master's degree in data analytics in economics and finance from the University of Glasgow and held various analyst and research roles.

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