In this game, the central bank plays the role of the referee and decision maker. It can raise or lower interest rates. When interest rates rise, borrowing becomes harder and more expensive, people spend less, and businesses invest less. As a result, inflation decreases. However, if the central bank lowers interest rates, the game shifts toward increased demand; people spend more, and businesses can borrow and operate more easily, causing inflation to rise.
Other players in the game, namely people, producers, and the government, all respond with their decisions. People's consumption or savings, companies' pricing, and government fiscal policies are all part of the game rules that shape its balance.
The winner of this game is the one who can maintain equilibrium: that is, not allowing inflation to rise too high nor the economy to remain in recession. If interest rates are set correctly and other players play their roles properly, the game moves in favor of all. However, if this balance is disrupted, the game will tilt toward economic instability.
Ultimately, the relationship between interest rates and inflation in this game is a responsive and regulatory one: interest rates determine the direction of the game, and inflation is the outcome that changes with every move.
What is Interest Rate?
Interest rate is the cost that must be paid for borrowing money or taking out a loan. In other words, the interest rate is the amount paid to compensate for the decrease in the value of money in the future, in exchange for the money that is provided to you today.
For example, suppose you take a loan of 10 million Toman from a bank with an annual interest rate of 20%. This means that at the end of the year, you must repay 12 million Toman. The 2 million Toman is a reward for the bank that provided you with the money, while it could have invested it in other ways.
Interest rates not only play a crucial role at an individual level, but also have a significant impact on the overall economy, as they affect investment, savings, inflation, exchange rates, and economic growth.
What is Inflation?
Inflation refers to the increase in the general price level in an economy, where the prices of goods and services consistently rise.
In simpler terms, inflation can be defined as the decrease in purchasing power of people, meaning that if a certain amount of money can buy a specific basket of goods today, due to rising inflation, in the future, only a portion of that basket will be affordable.
The term "basket of goods" refers to the collection of goods and services that households typically consume in their daily lives, such as food, clothing, rent, healthcare, and transportation. Economists measure inflation by monitoring the price of this basket over time.
Therefore, inflation is interpreted as the continuous decrease in the value of money, and when inflation is high, the cost of living increases. People tend to invest or purchase durable goods to preserve the value of their assets.
Why do interest rates and inflation affect each other?
Interest rates and inflation are like two thermostats in a house that need to work together to keep the temperature (the economy) at an optimal level.
Imagine inflation as the increase in the temperature of the house; when prices rise, the temperature inside gets warmer, and the value of money gradually decreases. The central bank acts like the second thermostat, and when it sees that the temperature (inflation) has gone up, it raises interest rates, just like turning on the air conditioner to bring the temperature down.
When interest rates rise, people and businesses borrow less and spend less, just like closing the windows to prevent more heat from entering the house. This helps lower the temperature (inflation).
However, if the air conditioner stays on too long (interest rates are too high), the house becomes too cold, and people can no longer live comfortably, causing the economy to slow down. In this case, the central bank needs to turn down the air conditioner (reduce interest rates) to bring the temperature back to a balanced level.
Therefore, these two thermostats (interest rates and inflation) are constantly adjusting and coordinating with each other to ensure that the economy remains stable and sustainable.
Tool or consequence?
Interest rates and inflation are two important and interconnected components in the economy, each playing a different role in decision making and policy formulation. To better understand this relationship, it is essential to know that one of these, the interest rate, is an active tool in the hands of policymakers and the central bank to manage the economy, while inflation is more of a result or consequence of this management and the overall behavior of the market. In fact, the central bank adjusts interest rates to control inflation and prevent price instability. This interaction creates a kind of cyclical game between interest rates and inflation, which affects the entire economy.
Interest Rates: A Tool of Central Bank Monetary Policy
Interest rates are set by the central bank to control the economy. When interest rates rise, the cost of borrowing increases, leading to a reduction in consumer demand and investment. This decrease in demand helps control inflation. Conversely, lowering interest rates makes borrowing easier, stimulating demand and increasing inflation. In this way, interest rates play an active, targeted role that the central bank uses to steer the economy.
Inflation: The Consequence of Economic Changes
Inflation represents the continuous increase in general price levels, which is the end result of changes in supply and demand, production costs, and economic policies. Inflation is not directly controllable by the central bank and is more recognized as a consequence or outcome of policies and economic conditions. When inflation rises, it indicates a reduction in the purchasing power of money, which can affect people's lives and economic activities.
The Interactive Game Between Interest Rates and Inflation
This economic game is played by several key players: the central bank that sets interest rates, the government that determines fiscal policies, businesses and individuals whose consumption and investment behavior alter demand, and the financial markets that react. This dynamic interaction means that any change in interest rates will provoke a reaction in inflation, and any change in inflation will prompt a response from the central bank. In this cycle, the main objective is to maintain economic balance and prevent severe fluctuations.
Types of Interest Rates and Their Applications
As previously mentioned, interest rates are set by central banks based on the policies and cultures of each society and are determined by many factors. Therefore, to implement these policies, it is necessary to use appropriate interest rates depending on the situation. These interest rates include:
Simple Interest Rate
Simple interest is the interest calculated only on the principal amount of a loan or investment. In other words, the interest for each period is applied to the principal amount, and past interest does not affect the calculation of the new interest.
For example, if you borrow 10 million Toman with a 10% simple annual interest rate, you will pay 1 million Toman in interest each year, without the interest from previous years being added to the principal.
Compound Interest Rate
In compound interest, the interest for each period is applied to the principal amount as well as the interest from previous periods. This means the interest is added to the principal each period, and the next interest is calculated based on this sum.
For example, if you have the same 10 million Toman with a 10% annual compound interest rate, in the first year, you will receive 1 million Toman in interest. In the second year, the interest is calculated on 11 million Toman (principal + first year interest), which is more than 1 million.
Fixed Interest Rate
A fixed interest rate is one that does not change throughout the duration of the loan or investment and always remains the same. This type of rate is suitable for those who want to predict their financial costs accurately.
Variable or Floating Interest Rate
In this type of interest rate, the percentage of interest may change over time depending on market conditions, economic indicators, or decisions made by the central bank. For example, the interest rate may be reviewed and adjusted every 3 months or every 6 months.
Interbank Interest Rate
This interest rate is the rate at which banks lend money to each other. Banks borrow from one another to meet short term liquidity needs, and this rate reflects the monetary and liquidity conditions in the interbank market. The interbank interest rate is usually an important indicator for the interest rates of other loans and facilities.
Annual Interest Rate
This interest rate is the rate set for a loan or investment over a full year. It is typically expressed as a percentage and serves as a benchmark for comparing the costs or returns of investments.
Effective Annual Rate (EAR)
The Effective Annual Rate shows the actual interest rate or cost if compound interest is calculated over different periods (e.g., monthly or quarterly). This rate is usually higher than the nominal rate and provides a more accurate comparison of interest rates.
For example, if the nominal interest rate is 12%, but the interest is compounded monthly, the effective annual rate will be slightly more than 12%.
Base Interest Rate
This is the interest rate set by the central bank and serves as the basis for other interest rates in the economy. Banks and financial institutions typically adjust their loan and deposit rates based on this rate. The base interest rate represents the cost of money in the economy and plays a key role in monetary policy.
When is the relationship between interest rates and inflation beneficial for the economy?
The game between interest rates and inflation is beneficial for the economy when a balance between the two is well maintained; that is, the interest rate is set in such a way that inflation is neither too high nor too low.
When the central bank carefully adjusts interest rates, the behavior of consumers, investors, and producers changes appropriately. For example, increasing interest rates leads to people borrowing less and spending less, which reduces price pressure and controls inflation. Conversely, lowering interest rates stimulates demand and economic growth, which is beneficial in times of recession.
However, if this game is not properly managed and interest rates or inflation move beyond balanced levels, the economy experiences volatility, reduced investment, higher living costs, or even recession. Therefore, maintaining a balance between interest rates and inflation is like managing a sports team where all players (people, businesses, the government, and the central bank) must act in coordination for the team to move toward success.
Ultimately, this is a cyclical and interactive game between interest rates and inflation that, with precise adjustments and responses to economic conditions, can lead to sustainable growth, price stability, and improved public welfare.Summary
The relationship between interest rates and inflation is one of the most critical dynamics in any economy. The interest rate serves as a monetary policy tool used by central banks to manage inflation and stabilize economic growth. When inflation rises, central banks typically increase interest rates to reduce borrowing and spending, cooling down price pressures. Conversely, during economic slowdowns, lowering interest rates stimulates borrowing, investment, and overall demand.
Maintaining the right balance between inflation and interest rates is vital too high an interest rate can slow growth, while too low a rate can fuel inflation. Ultimately, the relationship between these two factors is cyclical and regulatory, aiming to preserve economic stability and sustainable growth.1. Why does inflation decrease when interest rates rise?Because higher interest rates make borrowing more expensive. As a result, people and businesses borrow less, spend less, and demand decreases leading to slower price growth and lower inflation.2. What happens when interest rates are too low?When interest rates are low, borrowing becomes easier and cheaper. People and companies spend more, which increases demand and eventually drives prices up leading to higher inflation.3. Is raising interest rates always effective in controlling inflation?In most cases, yes. However, if inflation is caused by external factors such as rising energy costs or supply chain disruptions, increasing interest rates may have limited impact. In such situations, a combination of monetary and fiscal policies is needed.4. When is the relationship between interest rates and inflation beneficial for the economy?When interest rates are set at a level that allows economic growth to continue while keeping inflation under control not so high that it causes a recession, and not so low that it triggers excessive inflation.