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Maintaining a steady rate of inflation is a key part of a central bank’s remit, but it’s safe to say it can be a tricky job.
Over the long term, rising inflation is good. It’s a sign that an economy is growing, and provides a compelling reason to invest or spend cash – because any capital that isn’t earning returns will lose value.
But if inflation rises too high – particularly when wages haven’t also increased – then goods can become too expensive. At the extreme end of this you have hyperinflation, which can spiral to make a currency completely worthless.
So most central banks are tasked with maintaining an inflation rate of around 2-3% per year. And what’s the best way of maintaining steady inflation? Interest rates.
How do interest rates affect inflation?
Raising or lowering the base interest rate for an economy should either boost saving or boost spending. Both of those will have a wide range of knock-on effects for the economy, and eventually end up either raising or lowering inflation.
Raising the interest rate
Increasing the base interest rate raises the cost of borrowing for commercial banks. This encourages them to raise their own interest rates, meaning that businesses and consumers will find that saving gets higher returns and borrowing is expensive.
This lowers spending in an economy, causing economic growth to slow. With more cash held in bank accounts and less being spent, money supply tightens and demand for goods drops.
Lower demand for goods should make them cheaper, lowering inflation.