There’s been a lot of chatter about inflation over the last year or so. Are economists on the news just talking about the lung capacity required to inflate all the balloons at their kid’s 10th birthday party? Unlikely.
Inflation is the average rate at which prices are rising within an economy. This has several impacts on your daily life.
Why You Should Care
Because of inflation, as time goes on, you cannot purchase as much with your savings. If you had $100 in your wallet when sandwiches were $5, and you still have that $100 but sandwiches are now worth $6 a year later, then you can’t purchase as many sandwiches.
A steady rate of inflation (generally targeted to be around 2%) stimulates growth by encouraging spending – if your money is going to be worth less next year, then you might as well spend it now. That’s the simplified idea anyway.
This steady rate isn’t always achievable. Sometimes there are unforseeable events, such as a global pandemic, which requires a huge amount of fiscal stimulus (read: creating money out of thin air for the government). Yes, I said money is created out of thin air. So who is this magical and powerful alchemist?
The Central Bank
The central bank is normally an organisation independent from the government, that controls the monetary policy of a particular nation. It has control over the physical money supply (coins and paper money), as it can create as much as it likes, and it controls the cost of borrowing money through interest rates from it, by setting its own interest rates.
Interest Rates
An interest rate is the cost of borrowing money. When you borrow from a bank (in your case, a commercial bank), you pay interest. You don’t get the money for free. You have to pay an extra percentage of the borrowed amount every month to pay for the privilege of early access to that money, but you pay it back over time.
In the context of the national economy, however, “interest rates” normally refer to the Central Bank Interest Rate. This is the rate which the central bank lends to the government or commercial banks. When you hear “interest rates have risen” normally this is a shortening of “the central bank has raised interest rates”.
This interest rate is how much the banks receive from depositing money into the Central Bank
What do you care what interest rates the banks need to pay though?
How Central Bank Interest Rates Affect You
As stated above, the central bank controls the monetary policy of a country. Thus, it must have some mechanism to act on its plans. That mechanism is normally interest rates. Let’s look at how.
- Central bank raises their interest rates. Making it a more attractive place for commercial banks to put their money.
- Commercial banks – either:
a) deposit into the central bank to get a return on that higher interest, which takes money away from people who might want to get a loan. Or
b) continue loaning out the money but at a higher interest rate, than the one set by the central bank, to make it worth their while. - It’s now more expensive to get a loan for a business for example. A company was looking to expand but they can no longer get a loan to employ more people to keep up with demand. The company is forced to turn down new business. Dropping the companies potential productivity.
- People with variable interest rate home loans now have to spend more of their income paying back their mortgage. Which means they are spending less money on other things.
- When people are spending less money on things, business have to try to encourage them to spend that money, and therefore, will keep their prices low, to encourage consumers to buy.
- Because it’s more expensive to secure a new home loan, it means there are fewer home buyers. And what does the old supply and demand curve tell us? Lower demand means lower prices.
- Lower housing prices makes home owners feel poorer, and so they are likely to save more. Saving more means spending less, so has the same effect as point 5.
But wait, aren’t we a bit off-topic? Wasn’t this post about Inflation?
Well, we have gone full circle. Note that in point 5. one of the implications of rising interest rates is that companies will try to keep prices low. And the definition of inflation is the rate at which prices are rising. So, theoretically, increasing interest rates ought to decrease the rate of inflation.
Recessions
It’s nice that inflation is curbed by increasing interest rates, since we can be confident our money is still going to buy us approximately the same number of sandwiches tomorrow. However, if interest rates are unnecessarily high, this can stymie growth, or cause a contraction of the economy. If this contraction lasts several months, it’s labelled a recession.
From the perspective of one person in a recession:
- They receive less in income
- They spend less.
- Fewer luxuries like eating out, fewer technology upgrades
All other things being equal, life is worse. So why would we want to slow down growth, let’s just keep inflation and live a happy life!
Unfortunately it’s not so simple. The alternative is worse. Hyperinflation. When money becomes worthless.
