Does increasing interest rates reduce inflation?

Intro

It’s time that we talk about what’s going on in the economy. Inflation was 8.3 in the April survey; this is the highest inflation we’ve seen since the 1980s, and this is also far above the Fed’s inflation target of 2. 

This is quite alarming, and if the inflation continues to be at this level, it will only take eight years until your money is only worth half of its current value. Eight years, while at two percent inflation, it will instead take 34 years, a pretty big and substantial difference in the US. 

The feds have the task of controlling inflation, and to do this, they can, among other things, change the federal funds rate, but this works similarly in other countries. 

Interest Rates and the Economy

This interest rate will in turn affect other interest rates, such as the interest rates on your loans. A lot of analysts are trying to predict when the Fed will raise the interest rate and how much they will raise it. 

Not at least those who are trading and investing in interest rates, and interest rate increases will not only affect those of you with loans but will also have an impact on, for example, how our stock investments will perform in the future. 

Also, many foreign stock exchanges nowadays are following the U.S. interest rate announcements more than their corresponding domestic interest rates. Depending on the industry, companies will either lose or gain from an interest rate increase. 

Cost of Rapid Inflation

In general, most companies lose on an interest rate increase, and then their stock price will fall, respectively, but what’s the cost of the rapid? Cost of rapid inflation Now we’ve had decades of low inflation and even with negative interest rates in some countries without inflation rising. 

What we see now is likely the combined results of relief funds ended in fuel prices, which were caused by the conflict with Russia, which then spread to more industries, and now most goods cost more, not the least food. 

The shutdowns in China, which caused supply chain issues as a result, have also impacted the situation. What the feds are afraid of now is that you and I, as working people, will start demanding higher wages as compensation for the increased inflation. 

If wages start to rise, it could set in motion a scenario of stagflation of rising inflation, similar to the situation we had in the 1970s. At the same time, economic growth is being slowed down by the higher prices. 

This is a scenario that the feds and other central banks want to avoid. In the worst-case scenario, this can lead to stagflation. In other words, a situation with a recession and high unemployment at the same time as inflation. 

If inflation rises, central banks usually respond by raising the interest rate. This partly leads to us with loans having less money left in our wallets to buy other things, and on the other hand, companies find it more difficult to borrow capital as well as get higher costs for interest rate payments, of course, and this works.

Demand Shocks

Great in the usual scenario when the economy is doing well unemployment is low and demand for goods is increasing too much this is called a positive demand shock in economics in this situation.

There is a risk that the economy will overheat and inflation will increase then the central banks raise the interest rates we get less money in our wallets and then we cannot buy as many goods and the economy slows down a bit and cools off as our demand for goods decreases epic right.

It also works to regulate the interest rates when the economy is slowing down too much unemployment is increasing and the demand for goods is falling too much which we call a negative demand shock in economics.

In this case, the central banks can instead lower interest rates and speed up the economy again by giving us more money for consumption and increasing the demand for goods so an overheated economy means that the interest rates will rise.

This leads to lower inflation and higher unemployment while too slow of an economy means that the interest rate will be lowered which leads to higher inflation and lower unemployment so a fairly simple relationship however this is not really the.

Negative Supply Shocks

What is happening right now? What we see now is a completely different situation. Now we see something called a negative supply shock. We want to buy things, but there are no longer as many goods as we want since demand is greater than supply, prices rise, and inflation is a fact. 

During the pandemic, it was more difficult to obtain certain goods, such as computers and other electronics that contain semiconductors. Now, oil and natural gas are more expensive, not the least affecting those of you with cars. 

Electricity prices are expensive, especially for those of you living in Europe, and of course, this also affects industries that are more dependent on energy in these forms. 

Food production has also been affected. not least because Ukraine accounts for a lot of grain production but also because Russia is a major exporter of synthetic fertilizers and I don’t think we’ve seen the full effect of this yet many retailers have long contracts with their suppliers that detail lower prices yet.

Part 2

And therefore the price increases are not fully noticeable on storage shelves yet others have tried to take a part of the price increase themselves without passing it on to the consumers because it normally takes a little bit longer to change the prices of goods.

There is a certain inertia in the system the prices of goods in the store are thankfully not fluctuating as the prices of a stock for example would be rather unreasonable even if the cost for the producing company varies more and after all some prices of goods cannot be risen as much as producers might want without losing the consumers.

Altogether sooner or later these price increases will reach consumers as well to some extent the inflation increase can be reversed if the conflict between Russia and Ukraine is sold but I also think that other price increases are here to stay such as the increase in energy prices.

For example, not least energy production should become more environmentally friendly at the same time as the amount of electricity that will increase to replace oil.

For example, what should the feds do about inflation then and what do many other central banks do around the world? Well they raise interest rates of course but it’s not entirely obvious that this is the best solution, and not everyone agrees with this so will this solve the problem then?

The Phillips Curve

No not very much anyway because we will not be able to stop buying food driving to work heating our houses or turning on the lights. It’s still pretty basic stuff and no luxury goods we’re talking about here nor will higher interest rates be able to bring down the prices of these goods.

We will only get a double hit with even less left in our wallets both. Because the goods we need are more expensive and also because loans become more expensive. And a rise in interest rates will probably lead to a worsening of the economy and increasing unemployment.

If the interest rates are increased too much there is a risk of a recession and even higher unemployment. There is a known link between inflation and unemployment called the Phillips curve.

It mostly holds even if it has been questioned more recently the Philips curve looks like this and illustrates the relationship between inflation and unemployment.

Part 2

Now I’ve only made up these figures here to show us an example but here you see. For example, if the inflation is high like here when it’s six percent unemployment is lower and here in the example, it’s then three percent.

If we then pretend that the central banks think that six percent here is a bit too high inflation then they raise interest rates. So the inflation drops to three percent and then the unemployment here increases instead to four point five percent in the example.

Some believe that the central banks shouldn’t raise the interest rates at all because unemployment will increase and the impact of the interest rate increase would. Therefore be greater for fewer individuals while most of us will gain from the lower inflation.

So the few who will become unemployed will have to carry the whole financial burden. While if we don’t raise interest rates we will all share the financial burden more equally personally. I’m not sure what’s best here this is not an easy situation. But the central banks around the world are still expected to raise interest rates several times more already this year.

Part 3

So why would they still raise interest rates if it has a fairly limited effect that even risks making the situation? Even worse well one reason is that they are afraid that people like you and me will lose confidence in the central bank’s ability to control interest rates.

If the central banks can no longer control people’s expectations it’s believed that inflation can spiral out of control. The banks will have raised interest rates in part to show that they still can control the situation. If we no longer expect the banks to be able to keep interest rates at a two percent level in the long run.

But instead starts expecting higher inflation for a longer period we will also start demanding higher wages as compensation. Then prices will rise even more to compensate for that. And so a spiral of price and wage increases can drive inflation further.

So people’s expectations of long-term inflation are 2 and that we still believe that the central banks can control inflation is very important to them. Whether interest rate increases or not the reality is in any case we and the rest of the world just became poorer.

I hope you liked this video guys I thought I would test this format again. So let me know what you think in the comments and I’ll see you all next time

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