Interest rates and inflation — what gives?

2011-02-26 00:00

OFTEN when reading articles you’ll come across a sentence that goes something like “the Reserve Bank, concerned about rising inflation, has decided to raise interest rates”.

Several people have asked me to explain exactly how the relationship between inflation and interest rates works.

Inflation is a rise in prices that reduces the purchasing power of a unit of currency.

A simple model: imagine Sue, who earns R100 a year, buys as many loaves of bread as she can for R10 each. When inflation is zero, Sue can buy 10 loaves of bread a year. But let’s say that inflation is five percent per annum. Then, over the course of a year, the price of bread goes up to R10,50 a loaf. Sue can now only afford to buy 9,5 loaves with her R100. So, inflation can be understood as either a rise in prices (bread going from R10 a loaf to R10,50) or as a reduction in the value of a unit of currency (Sue’s R100 is now worth 9,5 loaves of bread when it used to be worth 10).

There are various schools of thought on the causes of inflation, but one school is definitely dominant: the monetarist school of economics believes that the most important factor that drives inflation is the growth of the money supply. Money comes from somewhere. The government creates money by printing it and, more importantly, by lending money to banks; money is also created by the fractional-reserve banking system. This whole system is a bit beyond the scope of this article. For our purposes, what you need to know is that the money supply is basically created by the process of lending and borrowing in the banking system. Monetarists believe that when the supply of money grows too quickly, inflation rises. At this point, tradition requires me to say that, in this view, inflation is the result of too much money chasing too few goods.

The money supply is created by lending and borrowing, and interest rates are, basically, the cost of borrowing and the reward for lending. When interest rates are high, people and companies are hesitant to borrow, and so the money supply grows slowly, which helps to control inflation. Conversely, when interest rates are low, people and companies are eager to borrow, and so the money supply grows quickly, which fuels inflation.

In South Africa, the Reserve Bank orchestrates this whole process, mainly by setting the level of interest rates. The Reserve Bank is constantly lending South African banks money. When the bank thinks that inflation is too high, it raises the interest rate it charges on that money (the repo rate). The banks, which must now pay higher interest rates to the Reserve Bank, then adjust the interest rate that they charge consumers and businesses. This slows down the growth of lending and thus the growth in the money supply: voila­! Lower inflation. However, there is the question: “How effective will raising interest rates be when the factors responsible for the increase in prices are external, i.e. rand-dollar, oil price, drought?”

This question actually gets at another school of thought on inflation — the Keynesian school. Economists in this tradition say that inflation can be caused by many factors, not just the money supply. One factor is what they call “cost push” or “supply shock” inflation — this is inflation that is caused by a sudden reduction in the supply of goods or services, or an uncontrollable increase in their production costs. It may seem that central banks can’t cope with this type of inflation. However, supply-shock inflation is almost always short-term, and studies have shown that in the long-term, inflation is virtually always associated with a rapid growth in money supply. The Reserve Bank is worried about the longer term. In the long run, interest rates and constraints on money-supply growth are the only, and most effective, way to contain inflation.

— Moneyweb.

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