Inflation and Interest rates simplified

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Inflation and Interest rates simplified

 

The word ‘inflation’ has become very common place today, with media hyping a lot about it. Statements like “Inflation declines to 7.5%” and “WPI rises to 4.5%” have become quite common in today’s newspapers. This gives rise to an important question: What is inflation and how does it affect our lives. Well, let us answer these questions and also take a look at how the interest rates can be used to monitor inflation.

 

What is Inflation:

You have bought in October a kg of rice for Rs 40. In November you buy the same rice for Rs 45. This means the price of a kg of rice has gone up. This is due to the effect of inflation. In simple terms, inflation is nothing but the increase in the prices of the goods and services. These prices go up due to various factors like levying of additional tax or increase in the tax rate, rise in fuel prices, excess availability of money etc.

Effects of inflation on our lives:

It is no doubt that the rise in prices or Inflation does affect everyone’s lives. The prices go up and so things become costly. As a result, our budgets go haywire, thus making it difficult to save or plan our finances. As a result, people start cutting down on their expenses. This in turn leads to a slowdown in economy as businesses do not get cash to operate their business. Consequently, they reduce their operations, leading to slowdown. Hence it becomes necessary to combat inflation.

 

Interest rates – the key to combat inflation:

As we have seen above, it is necessary for us to combat inflation. This can be done in various ways. One of them is to increase the interest rates once the inflation increases. One of the reasons that we saw for the increase in inflation is excess liquidity. This arises when the supply of money is in excess. This happens when the interest rates are low and the funds are easy to procure.

As a result, people with money can pay for the goods and services. According to Economics, the law of demand and supply states that higher the demand for a particular item, higher is its price. This leads to rise in prices for the goods and services, thereby giving rise to inflation. RBI, the central bank of India responsible for maintaining the balance of economy increases the interest rates, when the inflation increases.

What RBI does is increase the interest rates on the funds it lends to the banks. As the cost of the funds to the banks increases, they are forced to lend money to their borrowers at higher rates. This means that the borrowers get money at higher rate, thus increasing the cost of funds. This means they are not able to spend much. As a result, the cost of goods goes down, causing the inflation to decline.
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The relationship of inflation and interest rate is inversely related. Higher inflation results from the lower interest rate and vice versa. Hence governments around the world make a conscious attempt to keep the inflation low, since higher prices make the governments unpopular among its people.

While interest rates are just one of the key factors affecting the inflation, they have an important role to play in controlling the inflation. But at times this can be a short term measure as the real cause of inflation could be something like shortage of raw materials or weak economy. In such cases, simply tampering with the interest rates will do no good.

The country needs to take stringent steps to remedy the situation. Only then can the inflation be controlled.

 

About the author:
Laxmi Kasbekar is a financial planner based in Mumbai. She offers free financial planning services for those who want to achieve their dreams in life. She can be reached at laxkasbekar@gmail.com