The Relationship of Inflation to Interest Rates

Why do interest rates exist? Who in the world invented such a devious tool that it makes your initial loan more expensive than it really was? After all, aren’t we borrowing money for the simple fact that we lack it? Heck, such opportunism can really buy you an express ticket to the underworld.

But are interest rates really the work of the devil, as some say? Before we get to understand interest rates, we must first understand the factors that affect them. One of these factors is “inflation”.

Inflation can be described as the power of your dollar to buy items. It is related to the Consumer Price Index or CPI. Now the CPI measures the percentage increase in commodities over a fixed year. The fixed year is normally a year in which the economy of that country performed exceptionally well. The list of these products is now entirely at the discretion of the nation’s economic managers. Why? Because the world is full of different cultures. Some cultures eat a lot of rice, while others prefer corn. Some are heavy wheat consumers, while others are not. What is a commodity in your country may not necessarily apply to another.

Anyway, back to inflation. When prices rise, your dollar can buy less. Over time, prices tend to rise steadily. Therefore, your dollar today is not necessarily equivalent in value to your dollar tomorrow. Case in point: If you could buy four comics with your dollar when you were younger, guess what, Batman? You can’t even buy one these days at that price. That is inflation.

So how does this relate to interest rates? Investors, try to preserve the value of your money by investing in activities that have returns equal to or greater than the rate of inflation. Let’s say the local interest rate is set at 6.5%; the money you earn, save, and invest should be able to at least match that rate. Why, because at the end of the year, if your money had stayed inside the piggy bank, its value would have been eroded by that rate. So if you save $100 at the beginning of the year, at the end of the year its value would have been reduced by $6.50, leaving your $100 worth only $93.5.

In developed economies, interest rates on bank savings are typically equal to the rate of inflation. If competition is fierce between banking institutions, you will get higher interest rates and therefore more return on your money.

So, who decides the interest rate to use? Normally, it is the central bank of the country. Please note that the rate they will state is not something that needs to be followed. It’s a benchmark, so anything below that level is automatically a losing proposition for your investment.

So, to conclude, inflation is one of the factors that affect interest rates. When inflation rises or falls, the tendency is to also increase or decrease the reference interest rate.