Inflation vs Interest Rates

Difference between Inflation vs Interest Rates

Inflation can be defined as a persistent increase in the price level in an economy over time. The economy is not facing inflation if the price level increases suddenly in a single jump but does not continue increasing. Also, it is not inflation in there is an increase in price in any specific good or service or in relative prices of some goods or services. The interest rate is the rate at which banks can borrow money from the Central Bank. The interest rates such as the Federal Funds rate in the US or Repo rate in India are used by Central Banks to shape the monetary policy which is used to target an inflation rate.

Let us study much more about Inflation vs Interest Rate in detail:

If inflation is present, the prices of almost all goods and services are increasing. Inflation erodes the purchasing power of a currency. Inflation favors borrowers at the expense of lenders because when the borrower returns the principal to the lender, it is worthless in terms of goods and services than it was worth when it was borrowed. Inflation that accelerates out of control is referred to as hyperinflation which can destroy a country’s monetary system and bring about social and political upheavals. The inflation rate is the percentage increase in the price level when compared to a base year. Analysts use the inflation rate as an indicator of the business cycle and anticipate changes in the Central Bank’s monetary policy.

To calculate the rate of inflation, a price index is used as a proxy for the price level. A price index measures the average price for a defined basket of goods and services. The Consumer Price Index (CPI) is the most prevalently used indicator for inflation rate and widely used by many countries. The CPI indicator consists of a basket of goods and services representing the purchasing patterns of a typical urban household. For example, in the United States, the CPI basket contains Food (14.2%), Energy (10.5%), and all items less food and energy (75.4%) as the categories of estimating CPI. To calculate CPI, the Bureau of Labour Statistics in the US or similar organizations in any country (where basket percentages may be different) compares the cost of CPI basket with the cost of a basket in an earlier base period. The formula for calculating CPI is: –

Taking an example for calculating the CPI: –

Reference base period: –

Cheeseburgers –               200 x 2.5             =             500

Movie Tickets –                 50 x 7                   =             350

Automobile fuel –            300 x 1.5              =             450

Watches –                          100 x 12               =             1200

Cost of basket                                                    =          2500

Current period –

Cheeseburgers –                200 x 3                  =           600

Movie Tickets –                  50 x 10                  =           500

Automobile fuel –             300 x 3                  =            900

Watches –                            100 x 9                 =            900

Cost of basket                                                    =           2900

CPI = (2900/2500) x 100 = 116

The price index is 16% over the base period hence inflation rate is 16%.

Some other countries use the Wholesale Price Index (WPI) as a way of measuring inflation. In WPI, the changes in prices of goods in different stages of processing (raw materials, intermediate goods, and finished goods) are looked at to watch emerging price pressure.

To understand inflation happens or how a certain rate of inflation is targeted, one has to look at the interest rate set by any country’s Central Bank. Monetary policy refers to the Central Bank using the interest rate as a tool to affect the quantity of money and credit in an economy in order to influence economic activity. It is said to be expansionary when Central Bank decreases the interest rate which in turn increases the quantity of money and credit in an economy. Conversely when Central Bank increases the interest rate which reduces the amount of money and credit in an economy the monetary policy is said to be contractionary.

So the Central Bank uses the interest rate to affect the money supply and thereby targeting inflation. The quantity theory of money states that the quantity of money is some proportion of total spending in an economy and implies the quantity equation of exchange: –

Price multiplied by real output is total spending so that velocity is the average number of times per year each unit of money is used to buy goods or services. The equation of exchange must hold with velocity defined in this way. Monetarists believe that velocity and real output of the economy change only slowly. Assuming that velocity and real output remain constant, any increase in the money supply will lead to a proportionate increase in the price level. This increase in money supply is achieved by a decrease in interest rates. As interest rates are reduced, the people and businesses are able to borrow more money. The effect of more borrowing is that there is more consumer spending in the economy which increases inflation since the demand for goods and services is more. While the opposite happens in the case of increasing interest rates. If inflation increases beyond a certain level than Central Bank’s liking, they increase the benchmark interest rates so that borrowing decreases and consumers save more. Due to more savings and less disposable income, there is less spending and hence economy slows and inflation decreases.

Head to Head Comparison Between Inflation vs Interest Rates (Infographics)

Below is the top 5 difference between Inflation vs Interest Rates:

Key Differences Between Inflation vs Interest Rates

Both Inflation vs Interest Rates are causing the economy to grow but there are a lot of differences :

• In Inflation vs Interest Rates, Inflation can be defined as a persistent rise in the price level in an economy while Interest rates are monetary policy measures used by the Central Bank of any country to control the level of money supply and credit in an economy
• Inflation is dependent on the level of money supply in an economy which is decided by the Central Bank. The interest rates in an economy are dependent on many macroeconomic factors, one of which is inflation.
• Higher inflation will lead to higher prices of goods and services in an economy. It also leads to higher costs of living, higher borrowing costs, weakens the currency, etc. Lower inflation, on the other hand, indicates a slowdown in the economy and may bring a recession. Persistent low inflation can lead to higher unemployment, reduced demand for goods and services which may affect profits. Higher interest rates are set by Central Bank to control inflation. With higher interest rates, borrowing costs are more and hence consumers save more rather than spending which slows the economy and decreases inflation. Interest rates are reduced when there is a need to stimulate demand in the economy which leads to higher borrowing and higher consumer spending which leads to an increase in inflation.

Head To Head Comparisons Between Inflation vs Interest Rates

Below are the Topmost comparisons between Inflation vs Interest Rates

Conclusion

Central Banks all over the world have used various economic variables and indicators over the years to make monetary policy decisions. Currently, inflation targeting is the most widely used tool for making monetary policy decisions and is in fact, the method required by law in some countries. Central Banks in countries such as the UK, Brazil, Canada, India, Australia, Mexico, and European Central Bank currently use inflation targeting. Inflation targeting is used by either increasing or decreasing the benchmark interest rates in the economy.

The most common inflation rate is 2% and the target band is 1% to 3%. In countries like India which is on a path to higher growth, the inflation target is 4%. The reason the inflation target is not 0% is that variations around that rate would allow for negative inflation i.e. deflation, which is considered disruptive to the smooth functioning of an economy. Central Banks all over the world follow controlled inflation as the way forward for sustainable growth to the economy.

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