Effects of inflation on interest rates

The way the market has been behaving since the last few years, you should be familiar with the term ‘inflation’. The ongoing rise in the prices of goods and services produced by a particular economy is driving inflation. The inflation poses threat on the economic activity on a global scale. It causes a decline in the real value of money and thus creates difficulty for the consumers to purchase goods.

How is inflation measured?
Each country gauges the monthly income of a household based on certain parameters. On the whole it is the Consumer Price Index (or CPI) which is used to measure inflation. The CPI is calculated as the average price of goods and services purchased by a household. If we talk about India, it uses a different unit known as Wholesale Price Index (or WPI) to measure inflation. The distinction between CPI and WPI can be drawn from the fact that CPI uses data on behalf of retail prices, while WPI uses data from wholesale prices.
You might wonder that the government designs various fiscal policies to combat the economic slowdown and imposes different types of taxes and duties on goods and services to maintain its normal functioning, so why does it still fall prey to inflation? So what causes inflation?
Inflation is a phenomenon affected by the thwarting supply and demands of goods and services in the economy. The behaviour of any rise in wages, prices or interest rates also has its impact on inflation.

  1. If there is too much liquidity in the market, and the availability of goods and services do not match up to the level at which the liquidity in the market prevails, it may lead to inflation.
  2. If Banks expand their credit policy to other banks or firms due to excess liquidity, it is a sign of inflation in the market.
  3. Due to the prevailing trend of population explosion, there is an increasing demand of money and goods and services, and thus leads to inflation.

There are different states of inflation.

  1. If the inflation has a very high rate it is given the term ‘hyperinflation’. During hyperinflation there is a tremendous amount of price rise of goods and services and the government has to shell out huge sums to meet the growing price hikes.
  2. If there is decrease in the prices of goods and services, we call it ‘deflation’ or ‘negative inflation’.
  3. In the fiscal environment, there is a phase when the inflation rate drops. This is known as ‘disinflation’.
  4. While the economy is experiencing a downfall, it may at times come to a standstill and this situation has an economic term called ‘stagflation’.

How does inflation affect you?

  1. During inflation there is an overwhelming rise in the prices of goods, compelling people to reduce their rate of purchase, thereby reducing their rate of consumption.
  2. To overcome inflation banks (esp. central banks) increase their rates of interest.
  3. The higher the interest rate, the slower is the economy. This results into unemployment as the companies want to maintain their profit margin by reducing manpower.
  4. Rising inflation also causes fuel inflation.

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