# Why can an increase in inflation rate, increase interest rates?

A Random Walk Down Wall Street (2015 11 ed). pp. 224 Bottom - 225 Top.

Changes in the rate of inflation will similarly tend to have a systematic influence on the returns from common stocks. This is so for at least two reasons. First, an increase in the rate of inflation tends to increase interest rates and thus tends to lower the prices of some equities, as just discussed. Second, the increase in inflation may squeeze profit margins for certain groups of companies—public utilities, for example, which often find that rate increases lag behind increases in costs. On the other hand, inflation may benefit the prices of common stocks in the natural resource industries. Thus, again there are important systematic relationships between stock returns and economic variables that may not be captured adequately by a simple beta measure of risk.

• If the rate of inflation is 3% I might feel I can get an acceptable profit by lending you money at 5%. If inflation is 6%, lending you money at 5% is a bad deal (for me). – Hot Licks Sep 22 '18 at 12:15
• Do you want an explanation of that particular statement, or that particular statement in the context of stock returns? – Kitsune Cavalry Sep 22 '18 at 18:59
• @ KitsuneCavalry The former please, but both if this wouldn't take too much time? – Greek - Area 51 Proposal Sep 22 '18 at 21:33

Scenario A. Suppose the inflation rate is 2% (per year).

I lend you \$100 (for one year) at an interest rate of 5% (per year). Then after accounting for inflation, the real return I get in a year's time is† 5% − 2% = 3%. This 3% return is my reward for: • Deferring my own consumption (instead of using that \$100 some other way right now);
• Taking on the risk of you defaulting (i.e. not paying back); and
• Other transaction costs involved in executing this loan.

And this 3% is the cost you're willing to pay for the benefit of having that additional \$100 to spend right now. Scenario B. Now suppose instead the inflation rate is 4%. Suppose we're still willing to make the same deal. That is, I still get a 3% return as my reward (for lending you \$100) and you are still willing to pay 3% (for having that additional \$100 to spend now).

Then the interest rate we'd use for this loan would instead be‡ 4% + 3% = 7%.

†This is approximate. To be precise, the real return I get is actually $$\frac{1.05}{1.02} - 1 = 0.0294... = 2.94...\%.$$

‡Again, this is approximate. If we continue using the 2.94...% figure from above, then the interest rate we use for the loan should instead be $$1.04 \times 1.0294 ... - 1 = 0.0706... = 7.06...\%.$$

In a free currency exchanges market, the central bank defined goal, in the general case, is to maintain price stability and inflation rate restrained, that is to keep inflation positive but at a low rate, In order to encourage economic activity

Inflation can be manipulated by the amount of money - more money in the system, the lower its value, and higher prices respectively, and vice-versa.

The amount of money is manipulated by the central using interest rates: higher interest rates encourages deposits in banks and discourages taking loans, both actions leading to less money in the system, and vice-versa