How does raising interest rates help curb inflation?

[kuberkhan]

Pardon if the question is too naive.

How does inflation reduce if the central banks increase repo and reverse repo interest rates? I tried googling but multiple arguments are found, but the basic principle is the same. Increase the Supply.
Is that it?
For instance, in an economy like India where prices of day-to-day goods are controlled by many middle men? Is increase in interest rates just a tip on iceberg?

Thanks for your time!

 

[darth]

Increase the Supply.??? or rather Decrease the supply....

 

[Barny]

There was me thinking it was because it encouraged people to save rather than spend..

 

[hariadya]

I hope this answers the question

 

[Siddharth Singh]

Thanks hariadya, will it possible for you to give explanation in words too. I am unable to completely get the picture

 

[bigbadwolf]

Suppose hypothetically interest rates were 2% and now become 5%. If previously I was willing to take a loan to buy a car or a new house, I now become more reluctant to do so. If I have money in the bank, there is now more incentive for me to save (rather than consume) as I get some return on my modest capital. Industry becomes more reluctant to expand, to upgrade because 1) the cost of capital is higher, and 2) less demand is expected (see above); this reluctance means less demand for capital goods and construction. This is the gist of the argument. Since the economy slows down, there is more unemployment and if full employment was causing wages to go up, that ceases. Also because interest rates are higher, global capital flows in, driving up the local currency, making imports cheaper than locally produced (thus causing further decrease of demand), and further reducing inflation. This is the theory and this method of managing the economy was used roughly from 1945 to about 1975 (or thereabouts).

 

[hariadya]

As big baddie mentioned,
increase in lending rates, people will borrow less, hence spending decreases, they will save more thus reducing the demand and hence getting control over inflation but it takes time.
This is my knowledge so far.

 

[Tsotne]

I'll point a good article about the usage of repo interest rates for monetary policy that was attached to my economics coursebook. When I get home... @kuberkhan

 

[Tsotne]

http://www.cnb.cz/en/monetary_policy/instruments/
http://www.riksbank.com/upload/Dokument_riksbank/Kat_publicerat/Artiklar_PV/Otz_e.pdf
http://www.ecb.int/events/pdf/confe...n4_dunne.pdf?9f48ba8d856d44577a03a3cfd1e132db

 

[kuberkhan]

Thanks guys.
@hariadya, @bigbadwolf, @Tsotne.

 

[rajanS]

you cannot just increase the interest rates. there is something called FOMC (Federal open market committee) where the Federal reserve makes a decision on how many bonds to buy etc. When they sell bonds, there is less money out there in the market, hence the Money supply curve shifts to the left. Now, why does this shift cause interest rates to increase? Since quantity of money demanded at previous interest rate level was fixed, there is more money demanded than supplied. In order to have non monetary assets more attractive, their interest rates are bid up, i.e savings. Hence, there is a movement up along the demand curve and hence increasing the interest rates. When you buy bonds, money supply shifts to the right and hence interest rate decreases. Same reasoning as above.

 

[Tsotne]

you cannot just increase the interest rates. there is something called FOMC (Federal open market committee) where the Federal reserve makes a decision on how many bonds to buy etc. When they sell bonds, there is less money out there in the market, hence the Money supply curve shifts to the left. Now, why does this shift cause interest rates to increase? Since quantity of money demanded at previous interest rate level was fixed, there is more money demanded than supplied. In order to have non monetary assets more attractive, their interest rates are bid up, i.e savings. Hence, there is a movement up along the demand curve and hence increasing the interest rates. When you buy bonds, money supply shifts to the right and hence interest rate decreases. Same reasoning as above.

You described the classical monetary policy tool: Open market operation in this example. They also have other tools like Required reserves and Discount loans but the simple monetary policy theory which boils down to the money supply manipulation causing the interest rates to change cannot quite well explain the FED direct intervention in the market targeting the interest rates.

By increasing money supply, the vertical line shifts to the right dropping the interest rates:

When interest rates drop, it becomes more profitable (and affordable) for customers to take out loans and increase consumption. As a result, the aggregate demand curve shifts to the right surpassing the equilibrium which increases the overall price level in the country referred to as INFLATION. When money supply decreases (not surprisingly) vise occurs.



So the ultimate path is such: increasing the money supply causes inflation. But money suppy is not the only variable affecting the price level. Suppose the outbreak of fighting in some unstable country causes investors to become pessimistic about the future profitability of investment in the area and pull their money out decreasing the investments as a part of GDP. This causes the short run aggregate supply curve to shift to the left also increasing the price level. But in the long run, demands also fall in response since high prices cause aggregate demand to decrease (people cannot afford those prices) and the new equilibrium is found.

Having that said, no matter which tool FED implements to increase or decrease money supply in the economy (open market purchases, RR or discount loans), targeting interest rates became evident when FED chairman - Alan Greenspan informed congress in 1993 (if I remember correctly) that FED would cease using M1 and M2 to guide the conduct of monetary policy and put their emphasize on interest rates.

 

[rajanS]

You described the classical monetary policy tool: Open market operation in this example. They also have other tools like Required reserves and Discount loans but the simple monetary policy theory which boils down to the money supply manipulation causing the interest rates to change cannot quite well explain the FED direct intervention in the market targeting the interest rates.

By increasing money supply, the vertical line shifts to the right dropping the interest rates:

When interest rates drop, it becomes more profitable (and affordable) for customers to take out loans and increase consumption. As a result, the aggregate demand curve shifts to the right surpassing the equilibrium which increases the overall price level in the country referred to as INFLATION. When money supply decreases (not surprisingly) vise occurs.



So the ultimate path is such: increasing the money supply causes inflation. But money suppy is not the only variable affecting the price level. Suppose the outbreak of fighting in some unstable country causes investors to become pessimistic about the future profitability of investment in the area and pull their money out decreasing the investments as a part of GDP. This causes the short run aggregate supply curve to shift to the left also increasing the price level. But in the long run, demands also fall in response since high prices cause aggregate demand to decrease (people cannot afford those prices) and the new equilibrium is found.

Having that said, no matter which tool FED implements to increase or decrease money supply in the economy (open market purchases, RR or discount loans), targeting interest rates became evident when FED chairman - Alan Greenspan informed congress in 1993 (if I remember correctly) that FED would cease using M1 and M2 to guide the conduct of monetary policy and put their emphasize on interest rates.

nice nice. i remember studying all this 6 years ago. now i just remember the basics. I think economics is a must for every financial engineer. Its so important.

 

[hariadya]

could someone recommend a nice book that covers Economics as a whole please. A single book hopefully

 

[Tsotne]

could someone recommend a nice books that covers Economics as a whole please. A single book hopefully

I don't think it's a good idea to learn economics from a single book. It's more common and better way to learn Micro/Macro economics separately. I learned from these books ( I recently recommended to Neuron) and they are really good read. You'll like the structure of the books and explanations.

http://www.amazon.com/Hubbard-OBrien-Macroeconomics/dp/B0013KW93W
http://www.amazon.com/Microeconomics-MyEconLab-R-Glenn-Hubbard/dp/0130348260
http://www.amazon.com/Macroeconomics-2nd-Glenn-Hubbard/dp/0132356694

 

[hariadya]

Thank you @Tsotne

 

[hariadya]

got em! :]

 

[rajanS]

i remember using a book called 'macroeconomics by benjamin Bernanke' and 'andrew abel'. its a good book because its written by the current fed chair man...Micro economics is fun but i personally enjoyed macro much much more. if you really want to understand interest rates and unemployment and inflation, you should get this book called 'labor economics' by borgas. i remember reading it when i took a course in labor economics. its the best i think. If you are interested in learning currency and international trade economics, i would recommend 'international monetary and financial economics' by vanhoose. i personally loved the vanhoose book because the book deals with current issues, i.e 'how changes in deficits affects the current account etc. it also has a nice chapter on currency derivatives and hedging as a means to protect again deficit and bop structures. monetary policy and banks etc. very good book. if you need one economics book, get the vanhoose book.

 

[annedavis]

It's a great thing Ive learned concepts about economics in school. The inflation rate is an important economic indicator. It tells you how fast prices are changing in the economy. It's measured by the Consumer Price Index, or CPI. Moderate inflation is actually good for economic growth. When consumers expect prices to rise, they are more likely to buy now, rather than wait. This increases demand. In connection, there has been a lot of dialogue about how Americans are not saving much money or at least not putting it aside. Even if people were to up the rate of savings, inflation rates have virtually made it an unnecessary exercise. Read on.. Even if Americans upped savings, inflation makes it pointless

 

[bigbadwolf]

It's a great thing Ive learned concepts about economics in school. The inflation rate is an important economic indicator. It tells you how fast prices are changing in the economy.

Who'd ever have thought it, eh?

It's measured by the Consumer Price Index, or CPI.

Not really. The CPI is as rigged as the unemployment figure. The dollar is losing purchasing power faster than the US government lets on with its rigged figures.

Moderate inflation is actually good for economic growth. When consumers expect prices to rise, they are more likely to buy now, rather than wait. This increases demand.

By this logic the hyperinflation of the Weimar Republic should also have been good for "economic growth" -- after all, people were rushing out with their wheelbarrows full of paper money on payday looking to buy whatever they could before prices rose yet further. What impact this had on "growth" is not so clear to me. Nor am I convinced that even "moderate inflation" is good for "growth" either.

In connection, there has been a lot of dialogue about how Americans are not saving much money or at least not putting it aside. Even if people were to up the rate of savings, inflation rates have virtually made it an unnecessary exercise. Read on.. Even if Americans upped savings, inflation makes it pointless

The link is junk. First of all, they're using the official CPI as an authentic index of inflation. There is no savings account that matches real inflation. Secondly, it's a puerile argument that saving becomes pointless if interest rates on savings don't match inflation -- whoever said one has to save in a bank account? Do something else with one's savings. One still has to prepare for decrepit old age. And the way the US government is reneging on social security promises and introducing "chained CPI," there's not much solace to be found there. The Americans I know have been buying land and property abroad.