12-08-2006, 10:21 AM
The link between interest rate and inflation is an interesting one.
For instance, suppose you are in an environment where there is a higher inflation and the government is trying to control inflation. The government may increase the interest rates to control inflation. How would an increase in interest rates control inflation? To explain this in a detail, lets consider the following equation for the aggregate (total) demand in the economy
Aggregate demand = Consumption + Investment + Government spending + Exports - Imports
A rise in interest rate would possible result in a fall in consumption level as it would be expensive for public to borrow money and then spend it on buying goods. The level of investment would also potentially fall as it would expensive to borrow money. A higher interest rate also means that current accounts will earn more money. This would attract foreign investors buying your currency and then depositing it in your bank accounts. An increase in the demand for your currency makes your currency stronger and this would make your exports expensive and imports cheaper. Therefore, the overall impact of an increase in interest rate is a fall in aggregate demand. With aggregate supply remains constant, the general price level or the inflation in the economy will go down. The same argument could be used if the government reduces the interest rate. Hence, interest rates are used to control inflation.
The above argument contradicts with what Shahid said. In the equation that he provided for a price level, he assumed an interest payment. If the owner's capital is suffient and there is no interest payment to make, how would a change in interest rate affects the price level?
DT
For instance, suppose you are in an environment where there is a higher inflation and the government is trying to control inflation. The government may increase the interest rates to control inflation. How would an increase in interest rates control inflation? To explain this in a detail, lets consider the following equation for the aggregate (total) demand in the economy
Aggregate demand = Consumption + Investment + Government spending + Exports - Imports
A rise in interest rate would possible result in a fall in consumption level as it would be expensive for public to borrow money and then spend it on buying goods. The level of investment would also potentially fall as it would expensive to borrow money. A higher interest rate also means that current accounts will earn more money. This would attract foreign investors buying your currency and then depositing it in your bank accounts. An increase in the demand for your currency makes your currency stronger and this would make your exports expensive and imports cheaper. Therefore, the overall impact of an increase in interest rate is a fall in aggregate demand. With aggregate supply remains constant, the general price level or the inflation in the economy will go down. The same argument could be used if the government reduces the interest rate. Hence, interest rates are used to control inflation.
The above argument contradicts with what Shahid said. In the equation that he provided for a price level, he assumed an interest payment. If the owner's capital is suffient and there is no interest payment to make, how would a change in interest rate affects the price level?
DT
