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Sujai Adithya
Business Development and Banking & Financial Services Expert
Asked a question 9 months ago

What is the relationship between Inflation and Interest Rate?

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Sujai Adithya
Business Development and Banking & Financial Services Expert

Inflation is the rise of prices of goods and services gradually overtime. Interest is a major factor that impacts inflation rate.

When the demand is very low in the economy, the unemployment rate is high. Government has two solutions, 

  • Increase production level or
  • Decrease interest rate

Short term solution is to decrease the interest rate. Now people will get loans at lower rate of interest. This will give a short-term booster to the economy. As there are limited resources and people have infinite demands, people in the economy will start purchasing more than the production levels. Everybody starts fulfilling their needs using funds from loans. This leads to a high inflation rate. Inflation makes a direct impact on poor people in the economy. Now the government has to look for ways to decrease the inflation rate. The interest rate is increased, and hence the people borrow less and demand level decreases.

As we can see, inflation is directly proportional to interest rates.