Inflation vs Interest Rate

Inflation rate signifies the change in the price of goods and services due to inflation, thus signifying increasing price and increasing demand of various goods whereas interest rate is the rate charged by lenders to borrowers or issuers of debt instrument where an increased interest rate reduces the demand for borrowing and increases demand for investments.

The interest rate affects inflation and both are closely related. They are generally referred together in macroeconomics. In this article, we look at the differences between Interest Rates and Inflation.

What is Inflation?

Inflation is the rate at which the general level of prices for goods and services rises. As for price increase, this leads to falling in the purchasing power of the currency. It is very much necessary to keep inflation rate within permissible limits for the smooth functioning of an economy.

Let us understand inflation with an example- Suppose in 1990 a man buys petrol daily of INR 100 for his car and price of one liter was INR 40, in INR 100 he gets 2.5 Litres of petrol and now, if he buys petrol of INR 100 considering the current rate of petrol INR 90 per liter, he will get 1.1 L of petrol. Although INR 100 remains the same its purchasing power decreased by 28 years earlier, he gets 2.5L petrol at the same price as of today’s 1.1L of petrol. This is called inflation.

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What is Interest Rate?

The interest rate is the rate at which the lender is lending funds to the borrower. The interest rate has a vital impact on the economy of the country and has a major impact on stock and other investments.

The interest rate is decided by considering two factors.

  • Capital availability, if a rate of interest is high then capital is costly.
  • If the rate of interest is low, bank customers will not get sufficient return on their fund which will demotivate customers to keep the amount in the bank, as a result, the bank will not have funds.

If money is cheap, people will get the motivation to get money in the marketMoney In The MarketThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability.read more and as a result, the value of money will decrease. This will increase inflation.

The rate of interest for loans and deposit are different. The rate of interest for loans are high whereas for deposits comparatively less. The interest rate is a price for holding or loaning money i.e. price for depositing or borrowing of money.

Infographics

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Source: Inflation vs Interest Rate (wallstreetmojo.com)

To understand the relationship between these rates better it’s important to know about the Quantity Theory of MoneyQuantity Theory Of MoneyThe Quantity Theory of Money is an economic theory that defines the relationship between the money supply and the price of products. It states that an increase or decrease in the money supply will result in inflation or deflation, respectively.read more.

Relationship Between Inflation and Interest Rate

  • Quantity Theory of Money determines that supply and demand for money determine inflation. If the money supply increases, as a result, inflation increase and if money supply decreases lead to a decrease in inflation.
  • This principle is applied to study the relationship between inflation vs interest rate where when the interest rate is high, supply for money is less and hence inflation decrease which means supply is decreased whereas when the interest rate is decreased or low, supply of money will be more and as a result inflation increase that means that demand is increased.
  • In order to control high inflation, the central bank increases the interest rate. When the interest rate increases, the cost of borrowing rises. This makes borrowing expensive. Hence, borrowing will decrease and the money supply will fall. A fall in the money supply in the market will lead to a decrease in money with people to expense on goods and services. With the supply constant and the demand for goods and services will decrease which leads to falling of the price of goods and services.
  • In a low inflationary situation, the rate of interest reduces. A decrease in the rate of interest will make borrowing cheaper. Hence, borrowing will increase and the money supply will increase. With a rise in the money supply, people will have more money to spend on goods and services. So, the demand for goods and services will increase and with supply remaining constant this leads to a rise in the price level and that is inflation.

Hence,  they are inversely related to each other and have their own impact. As describe above if an interest rate is high, then inflation and money circulation in a market will be low and if an interest rate is less, then money circulation will be high in a market and hence inflation will increase.

Interest vs Inflation – Inverse Relationship?

Basis Interest RateInflation
Effect of Increase If the interest rate increase, inflation decreases
Money Circulations in the market decreases
Borrowing became expensive
Demand for goods & services decrease
Interest rate increase leads to a fall in the price of services and goods
If inflation increase, interest rate decreases
Money Circulations in the market increases
Borrowing became cheap
Demand for goods & services increase
Inflation leads to a rise in the price of service and goods
Effect of DecreaseIf interest rate decrease, inflation increases
Money Circulations in the market increases
Borrowing became cheap
Demand for goods & services increase
Interest rate decrease leads to a rise in the price of services and goods
If inflation decreases, the interest rate increase
Money Circulations in the market decreases
Borrowing became expensive
Demand for goods & services decrease
Inflation decrease leads to a fall in the price of services and goods

Through this, we can say that the inflation and interest rate are dependent on each other and the relation between them is an inverse relationship where one increases and other decrease and vice versa.

Final Thoughts

Inflation affects price of goods and services and these prices are very important for the customer as well for the seller as they want secure inflation where prices are stable or if in case it increases it should increase gradually. The purchasing power of their currency should not affect. Price stability is very much needed for a healthy economy. Considering this interest rate is decided. As to control inflation interest rate needed to change after a regular interval to maintain a healthy economy. Inflation vs Interest rate has a vital role in a market it helps the investor to calculate how much return his investment needs to make maintain his standard of living and investor invests in a product that gives return more than of inflation.

This has been a guide to the Inflation vs Interest rate. Here we also discuss the relationship between inflation and interest rates with infographics and comparison table. You may also have a look at the following articles –

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Comments

  1. Gregory says

    very useful content & well explained with examples. keep up with examples especially real life ones

    • Dheeraj Vaidya says

      Thanks for your kind words!

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