Impacts of Inflation

INFLATION AND INTEREST RATES: IMPACTS

Inflation and interest rates mainly run parallel to one another. Usually when interest rates are too low, the public is inclined to purchase too many assets, vehicles and household goods on credit, resulting in banks and moneylenders increasing the rates and this in turn BOOSTS inflation.

A change in the interest rate will tend to affect the price of financial assets such as bonds and shares, and the exchange rate. These changes in financial markets affect consumer and business demand and in turn output. Changes in demand and output then impact on the labour market - employment levels and wage costs - which in turn influence producer and consumer prices.

When interest rates are changed, demand can be affected in various ways:

It can affect spending and saving decisions. At higher interest rates, clients have less money to spend, due to the increased cost of borrowing. (Most people have loans, which they have to service every month, so if rates rise, monthly instalments increase and there is less money available for other things.) Spending by consumers in the shops and spending by firms on new equipment will therefore decrease. Conversely, a reduction in interest rates will tend to increase spending by consumers and firms.

A change in interest rates will affect consumers' and firms' cash flow, i.e. the amount of cash they have available. For savers, a rise in interest rates will increase the money received from the bank. It will however also mean higher interest payments for people and firms with loans - debtors - who are being charged interest. These include many households with mortgages on their homes. These fluctuations in cash flow are likely to affect spending. Lower interest rates will have the opposite effects on savers and borrowers.

A change in interest rates affects the value of certain assets, such as house and share prices. Higher interest rates increase the return on savings in banks and building societies. This might encourage savers to invest less of their money. Any fall in demand for these assets is likely to reduce their prices. This reduces the wealth of individuals holding these assets, which, in turn, might influence their willingness to spend. Again, lower interest rates have the opposite effect, i.e. they tend to increase asset prices.

Changes in the official interest rate take time to have their full impact on the economy and inflation. All the factors we have described have an impact on demand and, in turn, prices.

If consumer demand decreases, it is hoped, inflation will slow down. That is why Central Banks often increase