How do Interest Rates and Inflation Interact?

On 5 April, RBA decided to keep the record low cash rate at 0.1%. At the same time, petrol prices in Australia are skyrocketing due to Russia-Ukraine War. Many people believe that RBA will increase cash rate and further affect other interest rates to curb inflation. So what is the underlying relationship between interest rate and inflation? Cash rate is a monetary tool used by RBA. It represents the rate at which banks borrow and lend money to each other. High cash rate means that a bank has to borrow money from other banks at a higher cost and it will usually transfer this cost to customers such as individuals and businesses. They will have to borrow at a higher interest rate. Interest rate will affect inflation through four main channels. Let’s say Lily has an annual income of $67,901.6 and housing loan of $1,040,000. Her current average saving rate is 19.8% of her total income and loan rate is 2.36%. Saving and Investment Channel On average, the increase in interest rate means that the return on savings and investment will increase. Households will get more interest by saving more, so they will consume less. Lily’s current saving rate is 19.8%. If interest rates increase, she will be willing to put more money into her bank account and her saving rate will increase. She will spend less on groceries or luxuries. Everyone in Australia will have similar reactions as Lily’s. The aggregate demand for goods and services will decrease. Given a stable supply, prices will decrease and inflation will decrease. Cash Flow Channel For borrowers, the increase in interest rates will increase debt repayments. Lily’s current loan rate is 2.36% and so her first-year interest repayment is $24,544. If her loan rate increases to 4%, her first-year interest repayment will increase to $41,600. We can see that people will have less disposable income if they have to spend more on loan repayments. Similar to the previous channel, aggregate demand for goods and services will decrease. Accordingly, prices will decrease and inflation will go down eventually. Wealth Effect For large assets owners, the decrease in their asset prices will usually lead to their reduced consumption. This is called the wealth effect. When interest rates increase, people are less likely to buy large assets such as cars and houses due to possible high future interest repayments. Prices of these assets will drop because of the lower demand. If Lily’s house is worth less than before, she may feel that she is not as wealthy as before and so she will choose to spend less. Then same logic can be applied here. Aggregate demand, prices and inflation will go down gradually. Exchange Rate Channel Through the previous three channels, interest rates will only affect the national economy, by eventually posing impacts on national aggregate demand. However, interest rates in one nation can also affect the international economy. The increase in interest rates means that the returns on Australian investments will be higher and they will be more attractive to foreign investors. The Australian dollar will appreciate due to the increased demand and this represents an increase in the exchange rate. When our dollars are more expensive, it will be cheaper for us to buy foreign goods and services. Import prices will be relatively lower and this will lower the inflation rate. More quantitatively, the relationship between interest rates and inflation can be captured by an equation called Taylor Rule: Interest rate = 0.01 + 0.5*output gap + 0.5*inflation rate This equation shows that 1% increase in the inflation rate will correspond to 0.5% increase in interest rates, all else equal. Although this is just in theory and the magnitude may vary around different economies, this rule indicates the positive relationship between inflation and interest rates. When inflation increases, interest rates are one of the most effective monetary tools to curb inflation.

Vincy Mai

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