Inflation

The increase in prices over the last several years has caused public anxiety in virtually every part of world, including the United States of America. Today, inflation is considered by many Americans as a threat to their stable financial states. However, very few of them actually know the factors behind inflation and how is it going to effect their financial lives. Therefore, before examining further details on inflation and interest rate, we need to know what these terms really mean.

What is Inflation?

The American Heritage® Dictionary of the English Language presents the following definition for inflation.

“-----A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”

The definition quoted above elaborates that inflation is simply an increase in the value of the money caused by a decrease in the value of currency. Producing larger volume of currency decreases its value and more money will be required to buy goods. This is known as inflation.

Causes of Inflation:

Unfortunately, there is no generally accepted cause of inflation, however, there are two widely accepted theories regarding inflation.

1, Demand-Pull Inflation:

According to this theory, inflation is caused by an increase in the demand for goods and services. People are willing to buy goods and acquire services and hence, they are ready to spend more money on their need. The point here is that demand is growing faster than supply. Consequently, this results in high prices of goods and services.

2, Cost-Pull Inflation:

Demands are increasing so rapidly that vendors are unable to meet such a high demand rate. To overcome this, they need to increase their number of workers, number of machines, etc. Hence resources are increased. Similarly the cost of producing goods also increases. To maintain their profit margin, they increase their prices of goods. Again the value of material goes up and the value of currency goes down.

Relation between Interest Rate and Inflation:

Whenever we hear the latest inflation update on the news, chances are that interest rates are mentioned in the same breath. In the United States, interest rates are decided by the Federal Reserve. The Fed meets eight times a year to set short-term interest rate targets. During these meetings, the CPI and PPIs are significant factors in the Fed’s decision.

Interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, the Fed tries to achieve maximum employment, stable prices, and a good level growth. As interest rates drop, consumer spending increases and this in turn stimulates economic growth.

Contrary to popular belief, excessive economic growth can in fact be very detrimental. At one extreme, an economy that is growing too fast can experience hyperinflation, an acute or extreme version of inflation. At the other extreme, an economy with no inflation has essentially stagnated. The right level of economic growth, and thus inflation, is somewhere in the middle. It’s the Fed's job to maintain that delicate balance. A tightening, or rate increase, attempts to head off future inflation. An easing, or rate decrease, aims to spur on economic growth. Keep in mind that while inflation is a major issue, it is not the only factor informing the Fed’s decisions on interest rates. For example, the Fed might ease interest rates during a financial crisis to provide liquidity (flexibility to get out of investments) to U.S. financial markets, thus preventing a market meltdown.

Nominal interest:

Nominal interest is the rate of interest specified in loan contracts, without adjustment for inflation (Balkan, Erol, 1992).

Real interest:

The real interest rate is the nominal interest rate minus the rate of inflation, and thus is the interest rate adjusted for inflation.

The Fisher Effect:

According to the Fisher effect (Fisher, 1930) the nominal rate of interest on a financial instrument is equal to the sum of the real rate of interest and the rate of price change expected over the life of the instrument. More formally, the nominal rate of interest and the rate of price change expected over the life of the instrument.

The Fisher effect implies that there is a one-to-one relationship between the nominal rate of interest and the expected rate of inflation, thus indicating that the real rate of interest is constant. Usually the Fisher effect studies apply a short term interest rate and short-term rate of inflation. Lack of use of the long-term interest rate and the inflation rate is based on the belief that neither current nor past inflation rates provide an adequate guide to future long-term inflation.

Wallace and Warner (1993) showed that if one-period inflation rate is non-stationary in levels, then expectation of future inflation will be dominated by the current one-period inflation rate. A non-stationary one-period inflation rate (single unit root) implies that the innovations in it will ultimately dominate changes in expectations of future long term inflation (Wallace and Warner, 1993, p. 321). Based on the proof provided by Wallace and Warner (1993) it is very possible for the inflation rate to have a stationary long-run relationship with both the nominal long-term and short-term interest rates.

Works Cited

Balkan, E.M. & Erol, U., (1992), Inflation and Nominal Interest Rates in the United States, Economia Internazionale, pag.165-179

Fisher, I, (1930), The Theory of Interest, Macmillan, New York.

Wallace, M. and Warner, J., (1993), The Fisher effect and the term structure of interest rates: tests of cointegration. Review of Economics and Statistics, May, 320–4.