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Relationship Between Inflation and Interest Rates

The relationship between inflation and interest rates is one of great importance to investors.

The amount of inflation dictates how a country's central bank will set their monetary policy and thus how it sets its interest rates.

What are the benefits of low inflation?

There are many benefits to keeping inflation low since it means that the country's value of the money stays strong allows businesses to make better long term plans.

However, if inflation becomes high then people and investors may fear that this will erode their future purchasing power and choose not to invest there.

How do countries target this value?

To keep all these items in check, most countries aim for an inflation target of between 1 and 3 percent.

What is the relationship between inflation and interest rates?

If inflation is projected to be higher than this target, then central banks will typically increase their interest rates to make it more expensive to borrow and thus encourage people to save.

Whereas if it is projected to be lower, it will decrease interest rates to allow for more economic growth by making borrowing less expensive and thus encouraging people to invest.


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