The US Federal Reserve (usually called the Federal Reserve) recently announced that it would raise interest rates by 75 basis points (or 0.75 percent points).
The Federal Reserve is doing this to reduce inflation to the target of 2%.
- Inflation is basically a general rise in prices of goods and services and a decline in people's purchasing power. So when inflation happens i.e prices rise (without a corresponding increase in income), you can buy less than you bought before. You now have to pay more for the same thing.
- A rising inflation rate means that the inflation rate itself (where prices are rising) is rising.
- So imagine a scenario where inflation is 1% in March, 2% in April, 4% in May, and 7% in June.
- Interest rate is basically the percentage of the principal (the amount borrowed) that the lender charges on the borrower for the money it lent to the borrower. Not only that, it is part of the deposit that the depositor receives from the institution (bank or other).
- Therefore, from savings bank rates to loan rates, these rates are very important to the economy. Interest rates play an important role in a country's economic development and influence stock prices and other investment decisions.
Relationship between inflation and interest rates
- Inflation is determined by money supply and demand according to the theory of money supply (economic theory that defines the relationship between money supply and product prices).
- Money supply and inflation are directly proportional to each other. Simply put, this means that an increase in money in the economy causes an increase in inflation, and a decrease in money in the economy lowers inflation.
- When inflation fluctuates, the central bank (RBI in India) intervenes and changes interest rates to curb inflation.
RBI's role in controlling inflation:
- When inflation falls:
- When inflation goes down, RBI lowers interest rates. As a result, people are less interested in deposits and spend more than they save.
- Low interest rates also encourage people to borrow more by paying less interest. Overall, it causes personal consumption, and therefore demand.
If inflation rises:
- Inflation rises much faster due to higher demand, so RBI will step up again to raise interest rates. When interest rates rise, the interest rate on deposits rises, which increases savings and raises funding costs, so companies reduce borrowing.
- This will ultimately lead to a decline in the money supply in the economy. Again, by the Quantity Theory of Money lowers inflation and solves the problem of high inflation.
- Interest rates push inflation in the opposite direction.
- High interest rates reduce inflation and low interest rates increase inflation.
- The right level of inflation is good for the economy.
- RBI manages interest rates through monetary policy through a variety of actions, including lowering / raising interest rates and conducting open market operations.