How Interest Rates are Affected by Inflation

by William Blake

Inflation results in the decrease of the value of the dollar. That means that in the financing market, borrowers are more inclined to borrow money, but lenders are less inclined to make loans. A lender knows that the money he is paid back over time will be of less value than what he loans. To make up for their loss, lenders raise interest rates.

So, a vicious cycle is set up. As prices rise, more people (businesses, too) find themselves needing to borrow more if they are to buy the things they want – cars, home improvement, etc. That tends to raise interest rates even further, since there is now more demand for borrowed money. More demand, given a set supply, tends to raise prices. In this case, the price (this is interest paid) is the price of borrowed money.

Since inflation is chiefly caused by governments – whether through high borrowing themselves, or deficit spending, or actual printing of more currency or issuing more credit – there is little an individual can do to change the system. All one can do as a citizen is recognize the causes and advocate sound policies.

Fortunately governments are not increasing inflation at a steady rate so they are not constantly on the rise. If they were interest rates would reach an unimaginable rate as they did back in the 70’s. So borrowers need to keep an eye on the situation and act accordingly.

The government controls inflation by turning the tables on things to slow things down in the lending market. The lender and borrower in affect trade places as to their vantage point.

Deflation has as much affect on everyone as inflation. It means lower interest rates. So borrowing money is more appealing. But now the money you borrow will be of less value than it will be in the future. Your loss is that as you are paying on the loan the money you are giving up would be worth more if you could save or invest it.

So, when you consider borrowing you have to try to make a guess – just as the banks do – about which way inflationary or deflationary pressures are likely to go. That’s a tough job for even professional economists, so how can a laymen be expected to do that with any rationality?

There really is no method of calculation. But there are some things that give a good indication. In times past the dollar was related to hard commodity, gold and silver. So you could se these commodities as an indicator. That is no longer the case. But there are still some indicators out there that can give you some direction.

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