Effects of Raising Interest Rates on Inflation

What causes inflation? How is inflation bad for the economy? How can raising interest rate lower inflation? (1000)

Introduction

Inflation is defined as continuing rise in the general level of prices, such that it costs more to purchase a typical bundle of goods and services that is produced or consumed or both. In simple words, inflation leads to a decline in the real value of money. Sloman (2006) explains that the rate of inflation measures the annual percentage increase in prices. Consumer Price Index (CPI), which is published every month, is used to measure the rate of change in consumer prices.

Undoubtedly, inflation is an undesirable condition for an economy. Prior to discussing the consequences of inflation in the economy, it is important to understand the causes of inflation. Inflation may be caused by demand side factors or supply side factors.

As it can be seen from the above diagram in the case of demand pull inflation the AD curve shifts to the right because of an increase in demand which leads to an increase in output. Thus it is associated with a booming economy. The suppliers will only be willing to supply more at a higher price therefore increase the level of price. Whilst in the case of cost push inflation, there is an increase in price as a result in an increase in the cost of production independent of aggregate demand. This may occur as a result of increase in wages, or it might be that import price has increased irrespective of an increase in demand. There might be an increase in the level of taxes as well. Therefore any factor which contributes to an increase in the cost of production which leads to a rise in inflation causes cost push inflation. As a result of which there is a shift in the AS curve to the left. The suppliers will not bear the increased cost of production and instead will shift the price to the consumers by increasing prices and as a result fuelling inflation.

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Amongst several harmful effects highlighted Gwartney et. al (2000) argued that inflation distorted the information delivered by prices. They further stated that people responded to high and variable rates of inflation by spending less time producing and more time trying to protect themselves from inflation. Furthermore, inflation results in increased uncertainty which reduces the level of investment. A reduced level of investment would hamper economic growth, which further restricts people having a better standard of living and may also lead to unemployment. Further criticisms are that inflation redistributes income away from those on fixed incomes and those in a weak bargaining position to those who can use their economic power to gain large pay, rent or profit increases. Higher levels of inflation also worsens balance of payments position, a higher rate of inflation makes a country’s export less competitive in world markets and imports become cheaper and more attractive. Besides, extra resources are used to cope with the effects of inflation.

Increasing interest rates has been one of the solutions offered to combat increasing level of inflation. Inflation has for long been considered a monetary phenomenon and economists believe that inflation can best be tackled by adopting the monetary policy approach. The UK economy recently has been a good example of such measure. Inflation was 3.79% well above the 2% target and after the increase in interest rate in the past months to 5.5% and also an anticipated increase in interest rate has led the inflation rate to fall to 2.8% in April (Website: BBC). In the UK Bank of England sets the interest rates which controls the money supply and in turn controls inflation as well. The UK government follows a target and instrument approach to keep inflation under control. Increasing interest rates with a view to controlling inflation works in a manner that it reduces the money supply. People have an incentive to save rather than spend, therefore controlling the increasing rise in prices. This measure is a useful approach though the government should be careful to not continuously raise interest rates and curb spending because it would then adversely affect aggregate demand thereby slowing economic growth.

Besides interest rates, the government could also opt for fiscal policy measures by increasing level of taxes or may be reducing government spending and in that manner controlling supply of money, To tackle cost-push inflation, government could provide tax relief or provide subsidies to firms so that the cost of production reduces which could lead to the producers maintaining the level of prices rather than increasing them. Some economists have also stated that costs of inflation may be mild if the inflation is kept in single figures.

Conclusion

From the preceding paragraphs it can be said that increased level of inflation is not a desirable situation for an economy. However, a certain level of inflation is required in the economy to incentivise producers to produce more and better variety of goods and services. Inflation poses to be a problem when the level of increased prices dampens exports, reduces the competitiveness of a country and starts affecting the economic growth of the country by creating uncertainty and therefore leading to reduced level of investments. However, fiscal and monetary policy measures can be taken to control the increasing level of inflation. Increasing interest rates, leads to a restricted flow of money supply, resulting in reduced level of spending, saving more, demanding less of goods and services and therefore leading to a slower increase in price levels. Fiscal policy measures could also be used to combat inflation. More importantly for an economy to grow reducing levels of inflation is an important macroeconomic objective. In conclusion it can be said inflation can be adversely affect levels of economic growth if allowed to go out of hand and increasing interest rates is undoubtedly one of the ways, though not the only way, to tackle inflation.

BIBLIOGRAPHY

1. Dornbusch, R., Fisher, S., Macroeconomics, (2000), Eighth Edition, Mc-Graw Hill Education
2. Griffiths, A. and Wall, S., Applied Economics, (2001), Ninth edition, FT Prentice Hall
3. Gwartney, James D., Stroup, Richard L., and Sobel, Russell S., Economics Private and Public Choice, (2000), Ninth Edition, The Dryden Press.
4. Sloman, J., Essentials of Economics, (2004), Third edition, FT Prentice Hall
5. Howells, P and Bain, K, The Economics of Money, Banking and Finance, (2002), Prentice Hall

Journals and Articles

6. Carlstrom, Charles., Money Growth and Inflation: Does Fiscal Policy matter?, Federal Reserve Bank of Cleveland, April 15, 1999

Internet and Other Sources:

http://news.bbc.co.uk/1/hi/business/6656899.stm