Interest Rates & Inflation

[A380]

Is there any connection between inflation rate and interest rates? Can we correlate them? Can anybody give the answer?

[derivativetrader]

<blockquote id="quote"><font size="1" face="Verdana, Tahoma, Arial" id="quote">quote<hr height="1" noshade id="quote"><i>Originally posted by A380</i>
<br />Is there any connection between inflation rate and interest rates? Can we correlate them? Can anybody give the answer?
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There is very high correlation between the two. Intrest Rates are used by governments to control the inflation in the economy. Generally, a high inflation would result in an increase in the interest rate and vise versa..

[A380]

Can u explain me technically?

[Shahid_fss]

A high interest rate increases the inflation
Cost of Production + Interest paid on loan = Net Cost of production + Profit = Price

So in this equation put a higher interest amount and see how it will increase and decrease the price.

[derivativetrader]

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

[Schuaeb]

Interest rates have definitely got some correlation, however, things in actual world may somewhat different from what theories say in books.

Interest rates are an important monetary tool to control inflation. Example of Pakistani economy is there. The former State Bank’s Governor Ishrat Hussain dramatically reduced the interest rates. At that time it was claimed that the inflation is under control, PSBR (public sector borrowing requirement) is low (PSBR is used for financing fiscal deficit from internal sources). The result for this step was very much there. Primarily low interest rate policy was made to boost investment. Borrowings, especially in the SME sector, showed some significant rise. However, the primary target was not achieved a great deal. Money, withdrawn from the banks, was invested in speculation business. And the foreign remittances, which witnessed quite some hike at that time, was not deposited in banks or invested in some productive sector. Instead was invested in speculation business i.e. property. Resultantly, a very high rise in urban properties was witnessed. A high amount of money was injected in the society increasing consumption; inflation was to rise.

Afterwards, a U-Turn in State Bank’s policy was there, denying the government’s claim of consistency in policies. Interest rates were increased, as they had to be because the economy was confronting high inflation. In her recent speech, the present Governor Dr. Shamshad Akhter affirmed that high interest rates would continue, despite the ongoing objections of the business community.

High interest rates means more savings (as depositors are encouraged), lesser investment (real rate of return on capital is not high), lesser consumption and resultantly reduced inflation.

Shoaib

[derivativetrader]

<blockquote id="quote"><font size="1" face="Verdana, Tahoma, Arial" id="quote">quote<hr height="1" noshade id="quote"><i>Originally posted by Schuaeb</i>
<br />Interest rates have definitely got some correlation, however, things in actual world may somewhat different from what theories say in books.

Interest rates are an important monetary tool to control inflation. Example of Pakistani economy is there. The former State Bank’s Governor Ishrat Hussain dramatically reduced the interest rates. At that time it was claimed that the inflation is under control, PSBR (public sector borrowing requirement) is low (PSBR is used for financing fiscal deficit from internal sources). The result for this step was very much there. Primarily low interest rate policy was made to boost investment. Borrowings, especially in the SME sector, showed some significant rise. However, the primary target was not achieved a great deal. Money, withdrawn from the banks, was invested in speculation business. And the foreign remittances, which witnessed quite some hike at that time, was not deposited in banks or invested in some productive sector. Instead was invested in speculation business i.e. property. Resultantly, a very high rise in urban properties was witnessed. A high amount of money was injected in the society increasing consumption; inflation was to rise.

Afterwards, a U-Turn in State Bank’s policy was there, denying the government’s claim of consistency in policies. Interest rates were increased, as they had to be because the economy was confronting high inflation. In her recent speech, the present Governor Dr. Shamshad Akhter affirmed that high interest rates would continue, despite the ongoing objections of the business community.

High interest rates means more savings (as depositors are encouraged), lesser investment (real rate of return on capital is not high), lesser consumption and resultantly reduced inflation.

Shoaib
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This is surely is inline with my arguments.

[insaan]

In a nut shell
its simply demand supply cycle
higher interest rate -- lower demand -- (assume supply constant) -- prices lower
lower interest rate -- higher demand -- (assume supply constant) -- prices higher

(just consider money as a commodity)

so u may say interest rate and inflation are inversely correlated..

this is what WOrld Bank Pakistan's country manager recommended today -- he recommended to have a strong monetary policy , by increasing interest rates -- and so on....

[Schuaeb]

Derivative trader that was surely inline with your arguments. That was just to explain the concept to the extent I knew.