Chapter 15.2, Problem 5R

To determine

To evaluate: The relation between inflation and interest rates.

Explanation of Solution

In a fractional reserve banking system, interest rates and inflation appear to be correlated inversely. This relationship forms one of contemporary monetary policy's central tenets: Central banks control short-term interest rates to influence the economy's inflation rate.

Generally speaking, as interest rates go down, more people will borrow more money. The effect is that customers have more money to spend, improving the economy and rising inflation.

With rising interest rates the reverse holds true. When interest rates rise, customers continue to invest when savings levels grow. Despite the spending of less disposable income as a result of interest rate hike, the slowing down of the economy and inflation is declining.

Economics Concept Introduction

Introduction: Inflation is a systematic rate of measurement at which a set of chosen services and goods over a given period of time raises the overall price level in an economy. This is the general price index rise, where a currency unit actually buys lesser than it did in previous periods. Therefore inflation, often measured as a percentage, indicates a decline in a nation's currency's purchasing power.