Inflation and interest rates are often linked, and frequently referenced in macroeconomics. Inflation refers to the rate at which prices for goods and services rise. In the United States, the interest rate, or the amount charged by lender to a borrower, is based on the federal funds rate that is determined by the Federal Reserve (sometimes called "the Fed").
In general, as interest rates are reduced, more people are able to
borrow more money. The result is that consumers have more money to
spend, causing the economy to grow and inflation to increase. The
opposite holds true for rising interest rates. As interest rates
are increased, consumers tend to save as returns from savings are
higher. With less disposable income being spent as a result of the
increase in the interest rate, the economy slows and inflation
decreases.
Under a system of fractional-reserve banking, interest rates and
inflation tend to be inversely correlated. This relationship forms
one of the central tenets of contemporary monetary policy: central
banks manipulate short-term interest rates to affect the rate of
inflation in the economy.
To understand how this relationship works, it's important to
understand the banking system, the quantity theory of money and
what role interest rates play.
The Delicate Dance of Inflation and GDP
Fractional-Reserve Banking
The world currently uses a fractional-reserve banking system. When
someone deposits $100 into the bank, they maintain a claim on that
$100. The bank, however, can lend out those dollars based on the
reserve ratio set by the central bank. If the reserve ratio is 10%,
the bank can lend out the other 90%, which is $90 in this case. A
10% fraction of the money stays in the bank vaults.
As long as the subsequent $90 loan is outstanding, there are two claims totaling $190 in the economy. In other words, the supply of money has increased from $100 to $190. This is a simple demonstration of how banking grows the money supply.
Quantity Theory of Money
In economics, the quantity theory of money states that the supply
and demand for money determines inflation. If the money supply
grows, prices tend to rise, because each individual piece of paper
becomes less valuable.
Interest Rates, Savings, Loans and Inflation
The interest rate acts as a price for holding or loaning money.
Banks pay an interest rate on savings in order to attract
depositors. Banks also receive an interest rate for money that is
loaned from their deposits.
When interest rates are low, individuals and businesses tend to demand more loans. Each bank loan increases the money supply in a fractional reserve banking system. According to the quantity theory of money, a growing money supply increases inflation. Thus, a low interest rate tends to result in more inflation. High interest rates tend to lower inflation.
This is a very simplified version of the relationship, but it highlights why interest rates and inflation tend to be inversely correlated.
The Federal Open Market Committee
The Federal Open Market Committee (FOMC) meets eight times each
year to review economic and financial conditions and decide on
monetary policy. Monetary policy refers to the actions taken that
affect the availability and cost of money and credit. At these
meetings, short-term interest rate targets are determined. Using
economic indicators such as the Consumer Price Index (CPI) and the
Producer Price Indexes (PPI), the Fed will establish interest rate
targets intended to keep the economy in balance. By moving interest
rate targets up or down, the Fed attempts to achieve target
employment rates, stable prices, and stable economic growth. The
Fed will raise interest rates to reduce inflation and ease (or
decrease) rates to spur economic growth.
Investors and traders keep a close eye on the FOMC rate
decisions. After each of the eight FOMC meetings, an announcement
is made regarding the Fed's decision to increase, decrease or
maintain key interest rates. Certain markets may move in advance of
the anticipated interest rate changes and in response to the actual
announcements. For example, the U.S. dollar typically rallies in
response to an interest rate increase, while the bond market falls
in reaction to rate hikes.
What is the relationship between real interest rat and inflation rate in the long run and...
What is the relationship between real interest rat and inflation rate in the long run and short run? explain with figure.
a. What is the relationship between real interest rate, nominal interest rate and inflation rate? b. What are the reasons for very high nominal interest rates in the 1980s? c. Explain ex-ante real rate and ex-post real rate.
1. i) Write down the relationship between real interest rate, nominal interest rate, and expected inflation. ii) Using the relationship from i), fill in the following table. iii) What does the Fed hope when it engages in monetary expansion to get the economy out of recession? iv) Which situation(s) in the filled-in table corresponds to Zero Lower Bound? v). Use two rows of the completed table to explain why with Zero Lower Bound is it necessary to have positive expected...
Long run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when the maintain full employment changes in step with the price level to O A. money wage rate OB. quantity of money OC. real wage rate OD. interest rate supplied and the when the money wage rate, the prices of other resources and Short run aggregate supply is the relationship between the quantity of potential GDP remain constant O A real GDP...
Consider the relationship between inflation, output, and unemployment. Think about the economy in the long run. In the long run, what determines unemployment? (2 points) In the long run, what determines output (GDP)? (2 points) In the long run, what determines inflation? (2 points) In the long run, is there a tradeoff between inflation and unemployment? Explain why or why not (3 points).
Distinguish between the short-run and the long-run in a macroeconomic analysis. Why is the relationship between unemployment and inflation different in the short-run and the long-run?
1. The long-run model determines determines a. potential output; long-run inflation, current output, current inflation b. potential output; unemployment, current output; long-run inflation c. current output; long-run inflation; unemployment, current inflation d. potential output; unemployment; unemployment, current inflation e. current output: unemployment; potential output; current inflation andwhile the short-run model and , and 2. The IS curve describes short-run movements in an economy via which of the following? ↑Interest rate ↑ Investment → ↓ Output ↑Interest rate → ↓Investment →...
1. What is the relationship between real interest rate, nominal interest rate and inflation rate? 2. What are the reasons for very high nominal interest rates in the 1980s? 3. Someone buys a 5 year government treasury bond at $P t a. Can the price be above face value? Why? b. Can the price be below face value? Why? c. If he/she wants to sell it after 2 years, will he/she makes a positive rate of return or negative rate...
According to the Fisher equation, the real interest rate is given by a zero. b. the nominal interest rate plus the rate of inflation c. the nominal interest rate minus the rate of unemployment. d. the rate of economic growth. e. the nominal interest rate minus the rate of inflation An implication of sticky inflation is that, through monetary policy changes, the Federal Reserve a. has no impact on inflation b. can alter the real interest rate in the long...
output andwhile the short-run model determines 42. The long-run model determines inflation. and potential; long-run inflation; current output; current a. potential; unemployment; current output; long-run b. current; long-run inflation; unemployment; current d. potential; unemployment; unemployment; current e current; unemployment; potential output; curren 43. In the equation I,/Y, -a, -b(R,-), if b is close to zero, investment is not very sensitive to real interest rate changes. is very sensitive to changes in the marginal product of capital. is very sensitive to...