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How to Fight Inflation, The Use of Interest Rates.
Financial Markets

How to Fight Inflation, The Use of Interest Rates. 

Inflation is a word often pronounced in economic and financial circles. It has both positive and negative effects to a country’s economy. For this reason, a country’s central bank is tasked with controlling inflation levels through a set of measures. The standard mode of controlling inflation is through the raising or lowering of interest rates. Below is how interest rates are used to fight inflation.

Central banks provide a benchmark rate for commercial banks in any economy. The benchmark rate is used to lend money to commercial banks, which then add their margin and pass on the new rates to their clients. Cognitively, this means central banks control the lending rates in an economy. As such, inflation can proactively or reactively be controlled using interest rates, the former is always better compared to the latter.

When inflation levels are high, it means that there is increased money supply in an economy which if not controlled can lead to high commodity prices and costs of living. Counteractively, central banks raise interest rates to help reduce the money supply in an economy and stabilize prices. Stable prices assure an economy of a strong currency that can be relied upon and remain functional both in the local and foreign markets. When central banks effectively pass their interest rate raises often called hikes to commercial banks, commercial banks pass on the new rates to their borrowers as earlier noted herein.

Effects of interest rate hikes are felt across an economy in areas that include real estate and mortgages. For instance, people on variable rate mortgages will pay more on their regular payments. Borrowing and existing loans that are not on a fixed rate become expensive and reduce available cash for spending hence lower money supply. Resultantly, inflation is lowered.

However, low inflation is not good if it lasts for long periods, neither is high inflation. The two have to be checked and controlled often. Low inflation translates to low economic activity, reduced money supply, and minimal job creation and scarce employment opportunities. To offset low inflation, central banks lower interest rates, and commercial banks follow suit. As a result, borrowing becomes cheap and money flows back to an economy; this stimulates growth. Jobs and economic activity increase, the effect can be felt by market participants as well as a nation’s citizenry. By so doing, inflation is raised.

Important to note is that the change in interest rates by central banks can take up to two years to reflect or be felt in an economy.

All of the above can be summarized as a function of monetary policy.

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