General Question

janbb's avatar

Can someone explain to me the relationship between raising interest rates and inflation?

Asked by janbb (60934points) 1 week ago
18 responses
“Great Question” (4points)

And why something that seems to hurt so many people is good for the economy? (And how much should I panic because my investments are tanking?)

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Answers

gorillapaws's avatar

Inflation is often a symptom of an overheated economy. Interest rates are a way of cooling the economy down. The Fed will raise the interest rates to cool the overheating economy and thereby reduce the inflation. That’s a gross oversimplification and may not be perfectly analogous to the current situation, but that’s the general historical relationship. Furthermore as interest rates go up, bonds become more attractive alternatives to stocks, which is why some will sell their stocks and move into bonds (which have more security, but lower returns in general). That drives stock prices down (further cooling the economy).

janbb's avatar

@gorillapaws I’ve understood already the first part of what you are saying. What I want to know is the why it does?

Also too late to edit but the question should read “Can someone….....

elbanditoroso's avatar

Quick and dirty answer:

Raising interest rates (like what the Fed did) makes money more expensive to borrow for companies and merchants and customers. So they will buy less.

Buying less means that there is more availability (thing’s won’t run out of stock.) Since there is more stuff to buy, (and supply and demand) prices will go down.

Pandora's avatar

When we as a nation borrow more than we have in cash then vendors and businesses will raise prices to cover the loss of actual revenue. So when you raise interest rates people borrow less and those vendors and businesses will lower the cost of items because they need to make the cost attractive and more affordable. Supply and demand. Less people can borrow so you will have less customers unless you make your stuff more affordable. Think of it as real cash versus promises (loans). A bird in the hand is better than one in the bush. At least that’s how I think it works. Take borrowing money to buy a car. Car vendors could afford to increase the prices on vehicles because more people borrowed from banks at low interest rates. So they had a steady stream of customers. Maybe even more customers than the actual cars on hand. So they increase the prices and those who could afford the higher price paid for them. So no incentive for the business to bring it back down to a lower profit. So now. Interest rates increase. They have to lower prices because now they have more cars than customers. So inflation on the vehicles goes down. They have to compete harder against other car vendors who also decreased their prices to bring in customers.

Zaku's avatar

@Pandora “When we as a nation borrow more than we have in cash . . .”
You lost me in the first clause:

- Does the present-tense “when” refer to some time period, or the current total balance?

- What do you mean by “we as a nation borrow”? The national debt? The deficit? Consumers taking out any kind of debt with any kind of credit? Total personal debts?

- How much does “the nation have in cash”? The treasury? Actual printed cash in circulation?

gorillapaws's avatar

@janbb “What I want to know is the why it does?”

@elbanditoroso Had a good answer. Just to expand on that, I would say that having access to cheap credit acts like an “economic lubricant” of sorts. Let’s say you’re.a growing bakery and you realize you could explode your cupcake revenue by purchasing a $50k mixer. You’ll have to hire an extra employee, but the large increase in output will make the unit price much cheaper per cupcake. You’ll buy in bulk and capture even more savings there as well. Now in the world with cheap credit, you take out a loan hire, the new employee and start making money. You earn more; your employee is now employed, paying taxes and spending money in the economy; the ingredient wholesalers are happy because you’re buying a ton more raw ingredients from them, the manufacturer of the mixer equipment is extremely happy as their sale to you helps pay for their labor and their suppliers. You’ll have no problem repaying that loan with all of the added revenue and things are rosy.

That one loan kickstarted a lot of positive economic growth and demand for labor. Now in the scenario where the loan is too hard to get, then none of those things occur. Now picture this kind of thing happening for all kinds of businesses across the country. That’s the best way to think about how that relationship works—at least the best way I could come up with late at night.

janbb's avatar

@gorillapaws Thank you. That’s clearer except that it still seems like the first scenario with cheap credit is a win-win for everyone.

gorillapaws's avatar

@janbb It is, but that frenzy of business activity drives up prices thereby causing inflation. In the economics classes I’ve taken, I was taught that an ideal economy would have a small amount of inflation something like 1.5% or so. That incentivizes investment but doesn’t erode the value of people’s portfolios enough to be too detrimental.

The idea is for the Fed to keep the economy on a low simmer and not have it get cold or boil over. Without intervention, the natural tendency of capitalist economies is to have these extreme swings of boom and bust. Regulations temper the highs but also reduce the frequency and severity of the lows. There are other factors in play as well such as the money supply that can expand and contract based on interest rates (see money multiplier). I’m just giving the superficial general overview of the concepts involved.

janbb's avatar

Not that we’re going to get it ever, but wouldn’t an increase in taxes on corporate profits be a good tool for decreasing inflation? I was reading an article in the Times today about auto sales and how much money dealers are making because they can charge high prices while there’s limited supply and high demand.

It seems like raising the interest rate decreases both supply and demand..

elbanditoroso's avatar

@janbb the excuse that corporations have used for decades:

—> taxing us poor corporations is really taxing our investors and shareholders – people like you. The corproation doesn’t pay taxes, it comes from the owners (the investors).

They have gotten away with that forever.

jca2's avatar

I’m wondering if, from the supply side, it would benefit auto manufacturers to decrease production and auto dealers to decrease their purchases, to keep the inventory low and prices high.

janbb's avatar

@jca2 I think that’s what has happened with the short supply of components in the past few years. It’s supposed to be quite hard to get a new car and they jack up the prices.

jca2's avatar

I know, @janbb. I’m wondering if it wouldn’t benefit manufacturers and dealers to keep that supply low so their profits can remain increased. Instead of making $500 or $1000 per vehicle sold, if they can make $10k profit per vehicle, how easy is that?

Pandora's avatar

@zaku I meant individuals and businesses. But I would think the national debt plays some role in it.

Zaku's avatar

@Pandora Thanks for trying, but when I try to analyze what you wrote, I can’t make any sense out of it.

smudges's avatar

@janbb auto sales and how much money dealers are making because they can charge high prices while there’s limited supply and high demand.

not arguing, just making an observation I’d sure like to know who’s saying there’s a limited supply. There are cars just sitting on lots all over the US, and probably the world. Just like airplanes…there are hundreds, if not thousands, sitting in what they call airplane graveyards. Look it up and you can see the pics; it’s disgusting. I think the powers that be make up whatever they want to tell citizens. There is no limited supply of cars, and I doubt there ever has been.

gorillapaws's avatar

@jca2 “I’m wondering if it wouldn’t benefit manufacturers and dealers to keep that supply low so their profits can remain increased.”

Let’s say Toyota tried this. Then Honda, Ford etc. would increase production to fill the void in the market. It only works when all manufacturers do this in tandem. That’s called collusion and it’s illegal. That doesn’t mean collusion never happens, of course.

smudges's avatar

Very good point, @gorillapaws

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