I have been reading about how an increase in interest rates causes inflation to decrease as there is less money in circulation. However; I have never seen an article explaining how interest rates are affected by rising or falling inflation (The opposite).Could someone explain to me how interest rates are affected by a changing inflation rate?


1 Answer 1


I would note this similar question on interest rates and inflation. I would summarise the answer there as follows.

  1. Short-term interest rates are set by the central bank (in most developed countries; things are different in places with currency pegs).
  2. Longer-term bond yields should roughly equal the expected path of the short-term rate (plus a term premium). One can debate this point, but it is a fairly standard assumption.

The answer therefore ends up: what is the effect of inflation on how the central bank sets policy? This is the subject of monetary economics, and is an open-ended topic that cannot easily be answered here.

In practice, we often see the central bank raising rates as the expected rate of inflation rises. Since they are worried about expected inflation, they do not automatically react to every wiggle in measured inflation. For example, a central bank may not react to an oil price spike. (Reactions varied during the 2008 oil price spike, with the ECB hiking, and the Fed not.)


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