Why must interest rates increase during periods of inflation?
Written and accurate as at: Mar 03, 2023 Current Stats & Facts
Inflation is a situation where the prices of goods and services in an economy rise steadily. This can be caused by various factors such as increased demand, scarcity of supply, and excessive money supply. When inflation sets in, it erodes the purchasing power of money, and the real value of savings, investments, and wages decreases. To address this, central banks, in our case, the RBA, often increase interest rates during periods of inflation.
Why do interest rates go up during inflation?
Interest rates are the cost of borrowing money. When there is inflation, lenders lose confidence in the value of money and demand higher interest rates to compensate for the loss of purchasing power. This is because when they lend out money, they want to ensure that they get back their money plus an amount that can buy the same amount of goods and services as the money they lent out.
The central bank raises interest rates to slow down the economy and reduce demand for goods and services. This is because high inflation rates often occur when there is excess demand, and prices of goods and services rise due to the increased demand. By increasing interest rates, the central bank discourages borrowing and encourages savings. This reduces demand, which puts downward pressure on prices and helps to reduce inflation.
What happens if the central bank does not take the necessary steps to control inflation?
If the central bank does not take the necessary steps to control inflation, it can negatively affect the economy. One example of such a situation is hyperinflation, which occurs when inflation spirals out of control.
An example of hyperinflation is Zimbabwe in the late 2000s. In 2007, Zimbabwe's inflation rate was 7,982%, meaning prices doubled every 24.7 hours. The government responded by printing more money, which further fueled inflation. By 2008, the inflation rate had reached an astronomical 231,150,888.87%. The value of Zimbabwean currency became worthless, and the economy collapsed. This led to widespread unemployment, social unrest, and poverty.
In addition, inflation can lead to a decrease in consumer confidence and investment. When inflation rises, people become uncertain about the future value of their money, and they start to spend less. This can lead to a decrease in economic activity and a potential recession.
Conclusion
In summary, interest rates go up during periods of inflation because inflation erodes the purchasing power of money. The central bank raises interest rates to discourage borrowing and reduce demand for goods and services. If the central bank does not take necessary steps to control inflation, it can lead to hyperinflation, economic collapse, and decreased consumer confidence and investment. Therefore, it is important for the central bank to act swiftly and decisively to control inflation before it spirals out of control.