The Co-relation between Demand and Supply, Inflation and Interest Rates
Under the Old Economy, Asset inflation and Interest Rates will always create a Bubble, and the FED cannot control the Economy by just printing money, it is just kicking the can down the road. In the New Economy, Bitcoin as a digital currency has no inflation, and the demand and supply of bitcoin is tightly regulated, central bankers cannot anyhow create credit in the banking system which will cause a bubble, you are in control of your own money, so all the risks are taken away from the economy, there will not be a financial collapse. Contributed by Oogle.
What is Inflation?
Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Inflation is a key concept of Macroeconomics. Central banks attempt to limit inflation and avoid deflation in order to keep the economy running smoothly.
Relationship of Interest Rate and Inflation
Inflation and interest rates are often mentioned in the same breath, and this is because Inflationand interest rates are closely related. In the United States, baseline interest rates are set by the central bank, the Federal Reserve Bank also known as the Fed. The Fed meets eight times a year to set short-term interest rate targets. During these meetings, the CPI and PPIs are significant factors in the Fed’s decision, because the Fed, as well as other major central banks, has a specific interest rate target in mind for the economy to achieve, usually 2-3% annually.
In order to control high inflation, the central bank increases the interest rate.
When interest rate rises, cost of borrowing rises. This makes borrowing expensive.
Hence borrowing will decline and as such the money supply(i.e the amount of money in circulation) will fall.A fall in the money supply will lead to people having lesser money to spend on goods and services. Hence, they will buy a lesser amount of goods and services. This, in turn, will lead to a fall in the demand for goods and services.
With the supply remaining constant and the demand for goods and services declining; the price of goods and services will fall
In low inflationary situations; the interest rate is reduced. A fall in interest rates will make borrowing cheaper.Hence, borrowing will increase and the money supply will also increase. With a rise in money supply, people will have more money to spend on goods and services. So; the demand for goods and services will increase and with supply remaining constant this leads to a rise in the price level i.e inflation.
Inflation and interest rates are often linked and frequently referenced in macroeconomics. Inflation refers to the rate at which prices for goods and services rise. In the United States, the interest rate, or the amount charged by lender to a borrower, is based on the federal funds rate that is determined by the Federal Reserve (sometimes called “the Fed”).
In general, as interest rates are reduced, more people are able to borrow more money. The result is that consumers have more money to spend, causing the economy to grow and inflation to increase. The opposite holds true for rising interest rates. As interest rates are increased, consumers tend to save as returns from savings are higher. With less disposable income being spent as a result of the increase in the interest rate, the economy slows and inflation decreases.
Under a system of fractional-reserve banking, interest rates and inflation tend to be inversely correlated. This relationship forms one of the central tenets of contemporary monetary policy: central banks manipulate short-term interest rates to affect the rate of inflation in the economy.
To understand how this relationship works, it’s important to understand the banking system, the quantity theory of money and the role interest rates play.
The world currently uses a fractional-reserve banking system. When someone deposits $100 into the bank, they maintain a claim on that $100. The bank, however, can lend out those dollars based on the reserve ratio set by the central bank. If the reserve ratio is 10%, the bank can lend out the other 90%, which is $90 in this case. A 10% fraction of the money stays in the bank vaults.
As long as the subsequent $90 loan is outstanding, there are two claims totaling $190 in the economy. In other words, the supply of money has increased from $100 to $190. This is a simple demonstration of how banking grows the money supply.
Quantity Theory of Money
In economics, the quantity theory of money states that the supply and demand for money determines inflation. If the money supply grows, prices tend to rise, because each individual piece of paper becomes less valuable.
Interest Rates, Savings, Loans and Inflation
The interest rate acts as a price for holding or loaning money. Banks pay an interest rate on savings in order to attract depositors. Banks also receive an interest rate for money that is loaned from their deposits.
When interest rates are low, individuals and businesses tend to demand more loans. Each bank loan increases the money supply in a fractional reserve banking system. According to the quantity theory of money, a growing money supply increases inflation. Thus, a low interest rate tends to result in more inflation. High interest rates tend to lower inflation.
This is a very simplified version of the relationship, but it highlights why interest rates and inflation tend to be inversely correlated.
The Federal Open Market Committee
The Federal Open Market Committee (FOMC) meets eight times each year to review economic and financial conditions and decide on monetary policy. Monetary policy refers to the actions taken that affect the availability and cost of money and credit. At these meetings, short-term interest rate targets are determined. Using economic indicators such as the Consumer Price Index (CPI) and the Producer Price Indexes (PPI), the Fed will establish interest rate targets intended to keep the economy in balance. By moving interest rate targets up or down, the Fed attempts to achieve target employment rates, stable prices, and stable economic growth. The Fed will raise interest rates to reduce inflation and decrease rates to spur economic growth.
Investors and traders keep a close eye on the FOMC rate decisions. After each of the eight FOMC meetings, an announcement is made regarding the Fed’s decision to increase, decrease or maintain key interest rates. Certain markets may move in advance of the anticipated interest rate changes and in response to the actual announcements. For example, the U.S. dollar typically rallies in response to an interest rate increase, while the bond market falls in reaction to rate hikes.
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