What's the connection between central banks raising interest rates and rising food costs?

What's the connection between central banks raising interest rates and rising food costs?

In The News:

• The Federal Reserve, America's central bank, announced recently that it would raise interest rates by 75 basis points (or 0.75 percentage points).
• This is done by the Federal Reserve to lower inflation to 2%.

What's today's article?

• What do Inflation and Interest Rates mean? Significance? How does it work?
• Relationship between the two

Inflation

• Inflation refers to the general increase in the prices of goods and services and the decrease in purchasing power of people.
• This means that inflation will rise without an equivalent increase in your income.
  • You can buy less than you used to, or
  • You will pay more for the same product now.
• An increasing inflation rate means that prices are rising at a faster rate.
• To put it another way, consider a scenario in which the inflation rate was 1%, 2%, and then 4% in April, and then 7% in June.

Interest Rates

• The interest rate is a percentage of principal (the amount that you borrow) that the lender charges the borrower for money lent.
• It's not just a fraction of the deposits that a depositor receives from an institution (bank, or other).
• These rates are crucial for the economy, whether it is interest on savings banks or interest on loans.
• The role of interest rates is crucial in the economic development and stability of a country. They have a significant impact on stock prices, as well as other investment decisions.

Relationship Between Inflation And Interest Rates

• According to the Quantity Theory of Money, inflation is determined by money supply and demand. This economic theory defines the relationship between money supply (money) and the price of a product.
• Inflation and money supply are directly related.
• It means increasing money supply in an economy causes inflation to rise, and decreasing money supply leads to a decrease.
• Inflation rates fluctuate and the central bank (RBI, in India) intervenes to adjust the interest rates in order to control it.

The role of the RBI in controlling inflation

• Falling Inflation
  • The interest rates are reduced by the RBI when inflation is falling.
  • People are therefore motivated to save more and get lower interest on their deposits.
  • Additionally, people are more likely to borrow more if they pay less interest.
  • It triggers consumer spending and, thus, the demand.
• Rising Inflation
  • The RBI will continue to increase interest rates as inflation rises due to high demand.
  • People will save more when interest rates rise because they will get higher interest on deposits. Businesses will reduce their borrowings, as funding costs will rise.
  • This will ultimately lead to a decrease in money supply.
  • The Quantity theory of money will again show that inflation will decline and that the problem of higher inflation can be solved.

Conclusion:

• Inflation is driven by interest rates in the opposite direction. Inflation is reduced by higher interest rates, while inflation rises with lower rates.
• Inflation should be controlled at the right level to benefit the economy.
• The Monetary Policy of the RBI regulates interest rates. It uses various measures, including reducing/increasing rates and open market operations.

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