The Relationship of Inflation to Interest Rates

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

But are interest rates really the work of the devil as some people say? Before we come to understand interest rates, we must first understand the factors that affect it. One of these factors is "inflation".


Inflation can be described as the power of your one dollar to purchase items. It is related to the Consumer Price Index or CPI. Now the CPI measures the percentage increase of basic commodities through a pegged year. The pegged year is normally a year in which the economy for that country performed exceptionally well. Now the list of these commodities is entirely at the discretion of the nation's economic managers. Why? Because the world is full of different cultures. Some cultures are heavy rice eaters, while others prefer corn. Some are heavy wheat consumers, while others aren't. What is a basic commodity in your country may not necessarily mean that it applies to another.

Anyway, back to inflation. When prices increase, your dollar gets to buy less. Over time, prices tend to steadily increase. Hence, your one dollar today is not necessarily equivalent in value to your one dollar tomorrow. A case in point: if you could buy four comic books with your one dollar when you were younger, guess what, Batman? You can't even buy one these days at that price. That is inflation.

So how is this related to interest rates? Investors, try to preserve the value of their money by investing in activities that have yields that are either equivalent or higher than the inflation rate. Let's say that the local interest rate is pegged at 6.5%; the money that you earn, save and invest, should be able to at the very least, match that rate. Why, because at the end of the year, if your money stayed inside the piggy bank, its value would've been eroded by that rate. So if you save 100 dollars at the start of the year, at the end of the year its worth would've been shaved by .50 leaving your 0 worth only .5.

In developed economies, bank savings interest rates normally equal that of the inflation rate. If competition is fierce between banking institutions then you will get higher interest rates thus more yield for your money.

So who decides on the interest rate to be used? Normally, it is the central bank of the country. Bear in mind that the rate they will declare is not something that needs to be followed. It is a benchmark, thus anything below that level automatically is a loosing proposition for your investment.

So to wrap up, inflation is one of the factors that affect interest rates. When inflation moves up or down, the tendency is to increase or decrease the benchmark interest rate as well.

The Relationship of Inflation to Interest Rates

Michael Russell Your Independent guide to Interest Rates