Art of the Story of the Interest Rate Effect
The term "inflation" has been all over the news lately — and it won't be the last time we hear it either. Even though it's a fairly common term, what, exactly, does "inflation" mean? And how does information technology relate to interest rates?
Here, nosotros'll break downwardly the meaning of both terms and explain the ways they tend to go mitt in mitt. For those who want a quick primer on economics, we'll also cover the causes and furnishings of inflation when information technology comes to the economy at large.
How Does Aggrandizement Affect Interest Rates
For those who aren't finance-savvy, macroeconomics is the study of how the economy behaves. Inflation and interest rates are kind of similar the peanut butter and jelly of macroeconomics, and then to speak.
While inflation and involvement rates are not the same things, they practice tend to be linked together. Before we delve into how ane influences the other — and vice versa — permit'southward break down both terms.
What Is Inflation?
To put it only, inflation refers to the trend of the purchasing power of coin to subtract over time. As the prices of appurtenances and services rising, the same corporeality of money won't exist able to buy every bit much as it used to once upon a time.
For instance, say yous had 34 cents back in 1920. Co-ordinate to census records from the Library of Congress, that'd be enough to buy you half a gallon of milk. Now, cut to 2015, and that same 34 cents has seen its purchasing power subtract dramatically over fourth dimension, fifty-fifty though it'south technically the same corporeality of money. Need evidence? That same half a gallon of milk costs $three.50.
How Does Inflation Work?
So, why don't prices simply stay put? Well, aggrandizement happens for a number of reasons, including the following:
- Economical Growth: When times are good and people have more money to spend, companies tin can go away with raising their prices, because, more likely than not, people will pay those prices.
- Supply and Demand: When a certain production becomes super popular, more people volition want to purchase it, so the visitor that produces it can accuse more, knowing that in that location are enough of people who will still buy the product.
- Government Regulations: Certain laws or tariffs can make it more expensive for companies to either produce goods themselves or import them from other countries. In order to keep their rising costs from affecting their profits, they pass the costs on to their customers in the form of college prices.
- National Debt: When the national debt goes up, the government has to detect a style to go along making payments. The first option? Heighten corporate taxes on large companies, which, in turn, will frequently shift the cost burden to their customers. Their 2nd option is to impress more coin, which can oft pb to higher prices on appurtenances simply because there's more than money to be spent. Both can lead to inflation.
- Commutation Rates: When the dollar becomes less in relation to the value of money in other countries, imported appurtenances are more expensive for retailers to buy, so they often raise the prices, again ensuring that the cost is transferred to customers.
Is Inflation Bad?
Whether inflation is a practiced or bad thing depends on how quickly it happens — and which side of information technology you're on. Let'southward suspension this idea downwards past looking at a few of the pros and cons of inflation.
Pros of Aggrandizement
- Raises the cost of assets over time. This applies to everything from stocks to property values, so information technology'due south good for certain kinds of investors.
- The idea of inflation is a huge motivator when it comes to investing in stocks. The idea here is that the value of the stocks volition ascension forth with inflation more they would if they were put into a savings account.
- Information technology may encourage spending due to the idea that information technology's ultimately cheaper to purchase now rather than later. In some instances, this can boost the economy.
Cons of Aggrandizement
- Because it raises the cost of assets over fourth dimension, buyers volition end upward paying more for anything from stocks to property.
- Aggrandizement can be a bad thing for investors whose major holdings are in cash or bonds, as it slowly eats away at the value of their holdings.
- If aggrandizement happens also rapidly, it can have a negative effect on the economic system by reducing the amount of money people are able to spend. This, in plough, tin can have a negative upshot on sales.
What Are Interest Rates?
Interest rates refer to how much a lender charges to borrow their coin. The average interest rate is a percent of the total amount of money loaned out over the grade of a twelvemonth and is often referred to equally the annual percentage rate (APR).
For a simple illustration, let'south say you wanted to borrow $100 from your bank for a yr at an interest rate of 10%. That would mean that you'd demand to repay the initial $100 plus the interest rate of ten% — or $ten.
Interest rates can also work the opposite manner around when, rather than borrowing money, you put the money you already have into a savings account. Say, for instance, that instead of borrowing $100 from your bank, you lot put $100 into a savings account with a .threescore% APR. (Unfortunately, at the moment, the yield on most savings accounts tends to be incredibly low). At the end of the year, y'all'd have the initial $100 plus 60 cents you earned in interest, for a total of $100.60.
The Relationship Between Inflation and Interest Rates
Although inflation and involvement rates tend to be pretty closely related, they tend to trend in opposing ways. In other words, when interest rates get down, inflation tends to go up. This is simply because more people are able to borrow coin at a lower rate, which results in more buying power in the economy at large. Equally a event, companies are able to raise their prices, knowing that customers will however exist willing (and able) to pay for their products.
On the other paw, when interest rates go up, aggrandizement usually goes down. In this instance, people can't afford to borrow as much coin and may fifty-fifty adopt to put it in savings if their banking company'southward savings account involvement rates go up. As a result, there'south less money being spent, which forces sellers to offer lower, more attractive prices.
How to Calculate Interest Rate Change with Inflation
If y'all want to delve deeper into how interest rates and inflation affect each other, written report up on the quantity theory of coin. In simple terms, the theory states that the more free-flowing money that's bachelor in the economy, the more likely it is that prices volition rise.
The near common method for computing the relationship between interest rate and inflation is by using the Fisherian Theory, and, specifically, the Fisher equation, which states that:
(i + i) = (1 + r) (ane + π)or i ≈ r + π
- i = the nominal interest charge per unit
- r = the real interest rate
- π = the inflation rate
Equally you might accept guessed, this can go a bit circuitous, so exist sure to bank check out this handy guide from the Corporate Finance Found if you lot're interested in learning more.
Source: https://www.askmoney.com/loans-mortgages/how-inflation-affects-interest-rates?utm_content=params%3Ao%3D1465803%26ad%3DdirN%26qo%3DserpIndex