5 Key Factors: Discover How Interest Rates Affect Inflation – Explained Simply

Have you ever wondered why the cost of a cup of coffee or a gallon of gas changes yearly? Or why your savings account earns more interest in some years than others? These changes often come down to two key economic concepts: interest rates and inflation. But don’t worry; you don’t need a degree in economics to understand them. In this blog post, we’ll break down these concepts in a way that everyone can understand.

What are Interest Rates and Inflation?

Before we dive into the main factors, let’s first understand what interest rates and inflation are.

Interest Rates: The Cost of Money

Think of interest rates as the price you pay for borrowing money. When you take out a loan or use a credit card, you’re borrowing money that you’ll need to pay back with a little extra. That “little extra” is the interest, and the rate at which it’s charged is the interest rate.

Inflation: The Rising Cost of Living

Inflation, on the other hand, is the rate at which the general level of prices for goods and services is rising. If you’ve noticed that your grocery bill is a bit higher than it was last year or that movie tickets cost more than they used to, you’ve experienced inflation.

Now that we’ve covered the basics let’s explore how these two concepts are connected. In the following sections, we’ll discuss five key factors that show how interest rates affect inflation. Stay tuned!

Factor 1: The Cost of Borrowing

One of the most direct ways that interest rates affect our lives is through the cost of borrowing money. Whether it’s a mortgage for a home, a loan for a car, or even the balance on a credit card, the interest rate determines how much extra we pay on top of the amount we borrowed.

How Interest Rates Affect Borrowing

When interest rates are low, borrowing money is cheaper. This means that people are more likely to take out loans for big purchases like houses or cars. On the other hand, when interest rates are high, borrowing money becomes more expensive, and people might think twice before making those big purchases.

Let’s illustrate this with a simple example. Suppose you want to borrow $10,000 to buy a used car. If the interest rate is 5%, you’ll pay an extra $500 (5% of $10,000) in interest. But if the interest rate rises to 10%, you’ll pay $1,000 in interest. That’s a significant difference!

Borrowing and Inflation: The Connection

But how does this relate to inflation? Well, when people borrow more money, they have more to spend. And when people spend more, businesses can often charge more for their goods and services. This increase in prices is a form of inflation. So, in a roundabout way, lower interest rates can lead to higher inflation.

To illustrate this, let’s say that a lot of people decide to take advantage of low-interest rates to buy cars. This increased demand might cause car dealers to raise their prices. If a car that used to cost $10,000 now costs $10,500, that’s a 5% increase in price, which is a form of inflation.

Factor 2: Shopping and Spending

Another important way that interest rates can affect our lives is through their impact on our shopping and spending habits. The interest rate can influence not only how much we spend, but also where we choose to spend our money.

How Interest Rates Affect Spending

When interest rates are low, borrowing money is cheaper, but it’s also less rewarding to save money. That’s because the interest rate is also the rate of return on savings. If the interest rate is only 1%, for example, you’ll earn just $1 in interest for every $100 you save in a year. That’s not much of an incentive to save.

On the other hand, when interest rates are high, saving money becomes more attractive. If the interest rate is 5%, you’ll earn $5 in interest for every $100 you save in a year. That’s a much better return on your savings.

Spending and Inflation: The Connection

So how does this relate to inflation? When people spend more money, businesses can often charge more for their goods and services. This increase in prices is a form of inflation. So, in a roundabout way, lower interest rates can lead to higher inflation.

To illustrate this, let’s say that a lot of people decide to spend their money rather than save it because of low-interest rates. This increased spending might cause businesses to raise their prices. If a pair of shoes that used to cost $50 now costs $55, that’s a 10% increase in price, which is a form of inflation.

In the next section, we’ll explore another way that interest rates can affect inflation: through changes in business investment. Stay tuned!

Factor 3: Business Decisions

Interest rates don’t just affect individuals—they also greatly impact businesses. The interest rate can influence businesses’ decisions about whether to invest in new projects, equipment, or employees.

How Interest Rates Affect Business Investment

When interest rates are low, it’s cheaper for businesses to borrow money. This can make it more attractive for them to invest in new projects or equipment or to hire more employees. For example, if a business can borrow $100,000 at an interest rate of 3%, it will only have to pay $3,000 in interest. That might be a price worth paying to invest in a new project that could bring in much more revenue.

On the other hand, borrowing money becomes more expensive when interest rates are high, discouraging businesses from making these investments. If the interest rate rises to 10%, the business would have to pay $10,000 in interest on the same $100,000 loan. That might make the new project seem less attractive.

Business Investment and Inflation: The Connection

So how does this relate to inflation? When businesses invest in new projects or equipment, they often need to buy more goods and services, which can drive up prices. And when businesses hire more employees, those employees have more money to spend, which can also drive up prices. Both of these effects can lead to inflation.

To illustrate this, many businesses decide to take advantage of low-interest rates to invest in new projects. This increased demand might cause the prices of goods and services to rise. If a piece of equipment that used to cost $1,000 now costs $1,100, that’s a 10% increase in price, which is a form of inflation.

In the next section, we’ll explore another way that interest rates can affect inflation: through changes in exchange rates.

Factor 4: Traveling Abroad

Interest rates can also impact the value of our money in other countries, which you might have experienced if you’ve ever travelled abroad. This is because interest rates can affect exchange rates, determining how much our money is worth in foreign currency.

How Interest Rates Affect Exchange Rates

When interest rates are high in a country, that country’s currency becomes more attractive to foreign investors. This is because they can earn a higher return on their investments in that country. For example, if the interest rate in the US is 5% and the interest rate in Europe is only 1%, investors might decide to buy US dollars and invest in the US to earn a higher return.

This increased demand for a country’s currency can cause its value to rise compared to other currencies. So, if you’re travelling from the US to Europe when interest rates are higher in the US, you might find that your dollars buy more euros.

On the other hand, when interest rates are low in a country, its currency becomes less attractive to foreign investors, which can cause its value to fall.

Exchange Rates and Inflation: The Connection

So how does this relate to inflation? When a country’s currency is strong (meaning it’s worth a lot compared to other currencies), imports become cheaper. This can lower the prices of goods and services in the country, which is a form of deflation. On the other hand, when a country’s currency is weak, imports become more expensive, raising the prices of goods and services, leading to inflation.

To illustrate this, let’s say the value of the US dollar rises compared to the euro because of high-interest rates in the US. This might make it cheaper for Americans to buy goods from Europe. If a bottle of French wine that used to cost $20 now costs $18, that’s a 10% decrease in price, which is a form of deflation.

In the next section, we’ll explore the final way that interest rates can affect inflation: through changes in government fiscal policy.

Factor 5: Government Decisions

The final factor we’ll discuss is how interest rates can influence our government’s decisions about spending and taxes. These decisions can have a big impact on the economy and on inflation.

How Interest Rates Affect Government Fiscal Policy

When interest rates are low, it’s cheaper for the government to borrow money. This can make it more attractive for the government to spend money on projects like building roads or schools or to cut taxes. For example, if the government can borrow $1 million at an interest rate of 2%, it will only have to pay $20,000 in interest. That might be a price worth paying to fund important projects or to give taxpayers a break.

On the other hand, when interest rates are high, borrowing money becomes more expensive, which can discourage the government from spending or cutting taxes. If the interest rate rises to 5%, the government would have to pay $50,000 in interest on the same $1 million loan. That might make new spending or tax cuts seem less attractive.

Government Fiscal Policy and Inflation: The Connection

So how does this relate to inflation? When the government spends more money, it often ends up in the hands of people, who then spend it on goods and services, which can drive up prices. And when the government cuts taxes, people have more money to spend, which can also drive up prices. Both of these effects can lead to inflation.

To illustrate this, let’s say the government uses low-interest rates to spend more money on public projects. This increased spending might cause the prices of goods and services to rise. If a construction company that used to charge $100,000 to build a road now charges $110,000 because of increased demand, that’s a 10% increase in price, which is a form of inflation.

In the next section, we’ll wrap up our discussion and review the main points we’ve covered.

Real-World Example: The Interest Rate Cuts of 2020

To bring all of these concepts together, let’s look at a real-world example: the interest rate cuts that took place in the United States in 2020 in response to the economic impact of the COVID-19 pandemic.

The Federal Reserve’s Response to the Pandemic

In March 2020, the Federal Reserve, which is the central bank of the United States, cut its target interest rate to near zero. This was done to encourage borrowing and spending and to stimulate the economy during a time of economic uncertainty.

The Impact on Borrowing

As we discussed earlier, lower interest rates make borrowing cheaper. In the months following the interest rate cuts, mortgage rates fell to record lows. This led to a surge in home purchases and refinancings. For example, a homeowner with a $200,000 30-year mortgage could save about $100 monthly by refinancing when rates fell from 4% to 3%.

The Impact on Spending

Lower interest rates also make saving less attractive, which can encourage spending. While the pandemic certainly affected spending habits, lower interest rates likely contributed to increased spending in certain sectors, such as home improvement, as people spent more time at home.

The Impact on Business Investment

Lower interest rates also make it cheaper for businesses to borrow money, which can encourage investment. For example, a business that could borrow $1 million at an interest rate of 5% would have to pay $50,000 in interest. But if the interest rate fell to 2%, the business would only have to pay $20,000 in interest, making borrowing and investing in new projects more attractive.

The Impact on Inflation

All of these effects can contribute to inflation. While the overall inflation rate remained relatively low in 2020 due in part to the economic slowdown caused by the pandemic, certain sectors saw price increases. For example, increased demand for homes, driven in part by low mortgage rates, led to increases in home prices. According to the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, home prices increased by more than 10% in 2020.

However, inflation began to rise as the pandemic continued, and the Federal Reserve had to raise interest rates to combat it. In July 2022, the Federal Reserve enacted its second consecutive 0.75 percentage point interest rate increase, taking its benchmark rate to a range of 2.25%-2.5%

Increase in Interest Rates

Interest rates have rapidly increased recently as monetary policy has tightened in response to higher inflation. However, according to the International Monetary Fund (IMF), recent increases in real interest rates are likely to be temporary. When inflation is brought back under control, advanced economies’ central banks will likely ease monetary policy and bring real interest rates back towards pre-pandemic levels. The IMF suggests that how close to those levels will depend on whether alternative scenarios involving persistently higher government debt and deficits or financial fragmentation materialise.

Wrapping Up: The Connection Between Interest Rates and Inflation

We’ve covered a lot of ground in this post, so let’s take a moment to review the main points. We’ve seen that interest rates can affect inflation in a number of ways:

1. The Cost of Borrowing: Lower interest rates make borrowing cheaper, which can lead to increased spending and higher inflation.
2. Shopping and Spending: Lower interest rates make saving less attractive, which can also lead to increased spending and higher inflation.
3. Business Decisions: Lower interest rates make it cheaper for businesses to borrow and invest, which can drive up demand and prices, leading to inflation.
4. Traveling Abroad: Higher interest rates can strengthen a country’s currency, making imports cheaper and potentially leading to deflation, while lower interest rates can weaken a country’s currency, making imports more expensive and leading to inflation.
5. Government Decisions: Lower interest rates can encourage government spending and tax cuts, which can increase demand and lead to inflation.

Our real-world example of the interest rate cuts in 2020 showed how these factors can play out in practice. While the overall inflation rate remained relatively low due to the economic slowdown caused by the pandemic, certain sectors saw price increases due in part to the lower interest rates.

Understanding the connection between interest rates and inflation can help us make sense of economic news and make informed decisions about our own spending, saving, and investing. So the next time you hear about the Federal Reserve changing interest rates, you’ll have a better idea of what that could mean for your wallet.