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I continue being puzzled by the interest rate rises being used as a lever to lower inflation in the present climate. If I understand correctly, the rationale of higher interest is to dampen demand across the economy.
But the present inflation appears to be driven by rising cost base of suppliers. Moreover the real wages stagnant. Higher interest then sounds like a recipe for stagflation.

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    $\begingroup$ Hi! What is your exact question here? Your post does not seem to contain one. $\endgroup$
    – Giskard
    Sep 8, 2022 at 13:31
  • $\begingroup$ Will try to put it in the form of a question then. Given that the inflation is rising along with unemployment, GDP is falling, do you think the Central Bank is making a mistake using interest rate rises to dampen inflation, when said rises commonsesically further increase the cost base, retard demand and investment? $\endgroup$
    – Hi There
    Sep 11, 2022 at 0:50

3 Answers 3

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Rising interest rate will reduce even cost push inflation (this does not mean it is desirable to increase interest rate when there is cost push inflation from welfare perspective).

For example, consider graph below. Initially due to shock to short-run aggregate supply price level increases (causing inflation). However, despite this sufficient shift in Aggregate Demand to the left will lead to equilibrium with original price level and thus would reduce inflation.

That does not mean doing so is desirable, but assuming CB executes it well there is no reason to think it would lead to stagflation (low output and high inflation at the same time).

enter image description here

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  • $\begingroup$ @HiThere stagflation happens when both things occur at the same time: gdp is falling and there is high inflation. The point of the diagram is to show that even if there is supply side reason behind inflation higher interest rate can bring inflation down. It will lead to lower output (so it is not necessarily good thing to do) but drop in output is not the same thing as stagflation since stagflation requires also high inflation $\endgroup$
    – 1muflon1
    Sep 9, 2022 at 23:51
  • $\begingroup$ My initial question was about interest rate rises seemingly adding to (already high) input cost pressures as well as housing - all against the background of stagnant real wages. All leading to stagflation. If I understood your answer you seem to agree; Due to aggregate supply price level increases (causing inflation) -> Aggregate Demand decreases at a higher price level equilibrium. Is this not the same as stagflation? You also mention an assumption that CB executes it (interest rate increase) well. Are there empirical studies demonstrating that CB interest rises manage economy 'well' $\endgroup$
    – Hi There
    Sep 10, 2022 at 0:01
  • $\begingroup$ GDP has commenced to fall and many economist predict the fall will accelerate to recession in the coming year. Inflation has accelerated to 8.525%. Perhaps there is some tech definition of stagflation, but in general I would call the present combination of decelerating GDP (projected to fall) and accelerating inflation stagflation-like $\endgroup$
    – Hi There
    Sep 10, 2022 at 0:57
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Raising the federal funds target rate (or interest rates by the ECB) will cool down the economy indirectly through higher bank borrowing rates. This will have an impact on inflation and employment. Usually, an increase in unemployment comes with a decrease in inflation. However, as you point out, it is also possible the effect of the rate hike is not sufficient to lower inflation (maybe due to supply chain issues or commodity prices), an event known as Stagflation.

Indeed, at first glance, it looks as if raising interest rates would likely lead to such an event. On the other hand, demand push inflation appears to be somewhat undermined, as Fiscal stimulus and bottom-line borrowing costs radically increased the purchasing power of consumers. Keep in mind that the respective CBs have also been indirectly managing the borrowing costs through QE/QT for far longer, and raising rates is also part of the program schedule. Having all of this in mind, I believe a stagflation period doesn't appear probable. I hope this answers your doubt.

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Rising interest rates on loans divert money out of loans towards... nothing (the money disappears). Rising interest rates on savings diverts money out of the economy into central bank savings. If the interest rate is 0.5%, anyone who was only making 0.2% on their investment might consider throwing away their investment and just putting their money in the central bank, which takes it out of circulation for the time being.

If there's less money, of course, there is less inflation.

What does this mean in real terms? Most lending is for speculative activity (the more speculative, the more lending) e.g. new skyscrapers or new businesses. People who borrow money to do these big projects are less likely to do them because borrowing the money costs more. And therefore the real resources used for these projects are shifted towards economic "base load" e.g. providing everyone with food and heat. (At least, that's the ideal world. In reality, the workers on this projects don't get paid so they can't get food or heat...)

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