How do interest rates affect Inflation in the economy?
21st Jun, 2022
Recent Economic turmoil faced by all the countries due the highest inflation in last four decades is undeniable.
- The central banks of the United States and UK are hiking interest rates in order to contain inflation.
- The term inflation appeared in America in the mid-nineteenth century related to something that happens to a paper currency.
- By the nineteenth century, economists categorised three separate factors that cause a rise or fall in the price of goods:
- A change in the value or production costs of the good,
- A change in the price of money which then was usually a fluctuation in the commodity price and
- Currency depreciation resulting from an increased supply of currency.
- 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.
- At that time, the term inflation referred to the devaluation of the currency, and not to a rise in the price of goods.
- Today, however, it is understood as referring to a sustained increase in the general price
What is Inflation?
- Inflationis 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.
How do we measure it?
- The common measure of inflation is the inflation rate, the annualized percentage change in a general price index.
- As prices do not all increase at the same rate, the consumer price index (CPI) is often used for this purpose.
- The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs.
- GDP deflator is also a measure of the price of all the goods and services included in gross domestic product (GDP).
- It is defined as its nominal GDP measure divided by its real GDP
- The Wholesale Price Index: The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level.
- For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing.
Formula of Inflation calculation:
- Per cent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100
What are the factors affecting Inflation?
- Increase in Money Supply: Inflation is caused by an increase in the supply of money which leads to increase in aggregate demand. The higher the growth rate of the nominal money supply, the higher is the rate of inflation.
- Increase in Disposable Income: When the disposable income of the people increases, it raises their demand for goods and services. Disposable income may increase with the rise in national income or reduction in taxes or reduction in the saving of the people.
- Increase in Public Expenditure: Government activities have been expanding much with the result that government expenditure has also been increasing at a phenomenal rate, thereby raising aggregate demand for goods and services.
- Increase in Consumer Spending: The demand for goods and services increases when consumer expenditure increases. Consumers may spend more due to conspicuous consumption or demonstration effect.
- Cheap Monetary Policy: When credit expands, it raises the money income of the borrowers which, in turn, raises aggregate demand relative to supply, thereby leading to inflation.
- Deficit Financing: In order to meet its mounting expenses, the government resorts to deficit financing by borrowing from the public and even by printing more notes. This raises aggregate demand in relation to aggregate supply increasing inflation.
Steps to be taken to curb Inflation
- By Strict Monetary Policy: It refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.
- Maintaining Price stability: This will promote maximum employment, which is determined by non-monetary factors that fluctuate over time and are therefore subject to change.
- It also allows businesses to plan for the future since they know what to expect.
- Quantitative Easing: Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.
- Quantitative easing usually involves a country's central bank purchasing longer-term government bonds, as well as other types of assets, such as mortgage-backed securities.
- Demonetisation of Currency: However, one of the monetary measures is to demonetise currency of higher denominations.
- Such a measure is usually adopted when there is abundance of black money in the country.
- Fiscal Measures: Monetary policy if alone is incapable of controlling inflation it should therefore be supplemented by fiscal measures.
- Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and private and public investment.
Inflation is all together not only a bad omen for the Country’s economy but has advantages too. It is often used by many to curb their losses and income flows to their countries. However it can be controlled by the Governmental, the Central bank and Public efforts together.