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Link between rising food prices (Inflation) and central banks raising interest rates

  • Published
    22nd Jun, 2022
Context

As the inflation is increasing with higher pace reaching up to 9-10% even in most of the developed countries, banks are adopting fiscal and monetary measures to reduce inflation and its effects.

  • Recently US- Fed has decided to increase interest rates by 75 bps to control inflation by 2%. However, experts said that this step can cause recession in market.
Background
  • In economics, inflation is a general increase in the prices of goods and services in an economy.
  • When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money.
  • Following the proliferation of private banknote currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable banknotes outstripped the quantity of metal available for their redemption.

How inflation and interest rates are linked?

  • In a fast-growing economy, incomes go up quickly and more and more people have the money to buy the existing bunch of goods.
  • As more and more money chases the existing set of goods, prices of such goods rise.
  • In other words, inflation (which is nothing but the rate of increase in prices) spikes.

Inflation: Good or Bad?

  • Inflation describes a situation where prices tend to rise.
  • Economists believe inflation is the result of an increase in the amount of money relative to the supply of available goods.
  • While high inflation is generally considered harmful, some economists believe that a small amount of inflation can help drive economic growth.
  • The opposite of inflation is deflation, a situation where prices tend to decline.
  • The Federal Reserve targets a 2% inflation rate, based on the Consumer Price Index (CPI)

How interest rates dominate?

  • To contain inflation, a country’s central bank typically increases the interest rates in the economy.
  • By doing so, it incentivizes people to spend less and save more because saving becomes more profitable as interest rates go up.
  • As more and more people choose to save, money is sucked out of the market and inflation rate moderates.

Impacts on the economy

  • When growth contracts or when its growth rate decelerates, people’s incomes also get hit.
  • As a result, less and less money is chasing the same quantity of goods.
  • These results in either the inflation rate decline.
  • In such situations, a central bank cuts down the interest rates so as to incentivise spending and by that route boost economic activity in the economy.
  • Lower interest rates imply that it is less profitable to keep one’s money in the bank or any similar saving instrument.
  • As a result, more and more money comes into the market, thus boosting growth and inflation.

Risks of altering interest rates

  • If the Central bank cuts the interest rate, it may be fuelling retail inflation further.
  • It must be remembered that inflation hits the poor the hardest.
  • Can cause recession: Economic recession is the phase where economic activity is stagnant, contraction in the business cycle, over-supply of goods compared to its demand, a higher rate of the jobless situation resulted in lower household savings and lower expense.
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