Interest Rates, How to Address Inflation

We have explained in my last post where inflation comes from and how the governments benefit from it. Now when that inflation is higher than in the last 40 years, you and everyone else have noticed that everything costs more than usual. But how to address it?

The answer is raising interest rates. Instead of injecting money into the system, this time, we take it out of it. But What are interest rates? 

Let’s imagine taking a loan from the bank of 100 euros and 1% interest for 1 year. At the end of the year, you would have to pay back the bank those 100 euros + 1% of that amount (1 euro). Your bank’s job is to lend money to those who pay more for it.
Now imagine that the central bank set the interest rate at 1.25%, that would mean that if your commercial bank would lend its money to the central bank, they would get 1.25% interest as a profit. Which is higher than your initial 1%. In the end, if you want to get a loan from the bank, you would be competing with the central bank, and you would have to pay a higher interest, otherwise, your bank would prefer to lend its money to the central bank.

It is like if your bank would grow potatoes and sell them away. The only way for you to buy them is if you pay more than the other buyers. Just, in this case, we are talking about buying money instead of potatoes.

So if we define inflation as an excess of currency in circulation, the central bank raising interest rates would be the way for them to take that currency out of the system.

How does this affect you?

Well, for starters it will be more expensive to borrow money. You might not get a mortgage or the car you wanted, and you might have to buy less stuff. That will bring prices down. When demand reduces, prices decrease.

Companies will have to be more disciplined in managing their money because people will buy less from them. Some will have to delay their expansions or their investments. Some will have to reduce their staff to accommodate the new loan costs and decreased profits, and those in the most challenging situation might file bankruptcy. 

Currently, central banks have started to raise Interest rates (UK), about to (US), or are considering doing so (EU). The severity of its consequences will depend on how much they raise them. Consider that in a healthy economy, the interest rates are higher than the inflation rate. Nowadays, in Europe, the interest rate is near 0 % and the inflation rate around 5%, so there is a long way to get back on track.

In conclusion, the alternative of you losing purchasing power is raising interest rates. which will make people and companies spend less and so bring prices down with the possibility of triggering a new recession.

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