The relation between inflation and interest rates (1 Viewer)

[Aaron06]

Good day all,

You might be wondering by looking to your left that I finished the HSC last year. So to answer that yes I did, but I didn't do economics I did business studies.

As I am starting a new life as an adult and need to be interested in the rate of inflation and it's relationship for interest rates. I would like you to give me a few answers on this senareo as it would help you people learn as you teach me. =]

So here it goes,

What I don't get is when inflation rises it means the cost of everyday goods rises, which means businesses rises their price either due to whatever method they use. Then rising the interest rates will help the business cut costs to be more efficient. Is that the case?

Please note that I don't know much about prices of apples and the business etc etc and the figures just making it simple for simplictic purposes.

Lets say I run a business and I produce apples at $2/kg and has a turnover of 200k per annum and I just took out a loan for a new factory for 500k paying 2k per month for a number of years. Now the interest rate being 1% means an additional 5k on top of the 2k.

Now petrol and bananas increase dramatically as seen causing more pressure on inflation so the reserve bank increases the interest rate to 2%. My business now will have to pay back 10k. Which this pisses me off because at the moment I'll be making a loss and I can't afford this interest rate rise. So now I increase my prices to $3/kg.

Now times this senareo multiple times on different goods or services. It will turn out to be a never ending interest rate and inflation rise. So how does it work?

I don't need a huge 3 books on how it works. Just sum it up would be nice thank you. Just need to get the ignorance out of my head.

 

[Robbeh]

Re: Trying 2 get an understanding between the relation between inflation n interest r

What I don't get is when inflation rises it means the cost of everyday goods rises, which means businesses rises their price either due to whatever method they use. Then rising the interest rates will help the business cut costs to be more efficient. Is that the case?

MONETARY POLICY!

Cost of goods rises due to RBA raising interest rates as a result of inflation. When the IR (interest rate) is increased, this is an added cost to the business or firm. When a business encounters an extra cost of production they will generally pass it onto consumers because they wish to maintain a margin (profit). So when inflation rises, the RBA will raise interest rates preemptively (due to time lag) to kurb spending (RBA aims for ~3%). Once the economy has been slowed down (as seen by inflation figures), the RBA will either stop raising the IR or decrease it to encourage spending. This fluctuation occurs naturally and is cyclical.

Why will rising interest rates slow spending? You own a house. That is to say, you owe the bank a lot of money for living in their house. So when the IR rises, so will your mortgage. So while you're paying off your house and the IR has risen, you can't buy that extra caviar. Therefore, you'll spend less. Thus inflation will be curbed.

Why will the business encounter production cost? Same reason. You own a store. That is to say, you owe the bank a lot of money for working in that store... So to pass on your extra costs, you'll make your customers pay for it. Of course, you'll probably lose some customers as they can't afford it - unless you're selling necessities like salt or butter, but vintage wine, forget about it.

Everything in the economy will slow down.

Now times this senareo multiple times on different goods or services. It will turn out to be a never ending interest rate and inflation rise. So how does it work?

You're almost there. But think of this:
Inflation (spending) goes up, IR goes UP, inflation goes down.
Inflation goes down, IR goes down, inflation goes up.


Once it's slowed, the RBA will either decrease IR or leave it at the level. But that's a different kettle of fish.

Others may explain it in a greater depth (cash rate, flow on effects, transmission mechanism and so on), I have made it as clear as possible.

 

[-pari-]

What I don't get is when inflation rises it means the cost of everyday goods rises, which means businesses rises their price either due to whatever method they use. Then rising the interest rates will help the business cut costs to be more efficient. Is that the case?

Almost there, a bit muddled up though.
when inflation rises, yes it means the cost of everyday goods on the whole, goes up.
but rising interest rates- this is generally considered to be an extra cost for businesses [not a benefit] because businesses borrow from banks to invest, and so when the interest rate determines how much they have to pay back in servicing the debt of what they borrowed from the bank.
so increase in IR = increase in business costs because they gotta pay back more on their loans.

Now times this senareo multiple times on different goods or services. It will turn out to be a never ending interest rate and inflation rise. So how does it work?

well generally, when banks increase interest rates it makes things more expensive for ppl yeah?
for the masses it means they have to pay back more on the loans they already have and they're probably not gnna want to invest in anything any time soon, coz the price of borrowin would be too high.
so this would reduce their spending levels on the whole.
if they reduce their spending levels, then that means they're buying/demanding less as consumers,
meaning businesses dont have as many ppl to sell too, so they'll reduce their level of production.

remember that if IR rise, you might want to increase the price of your apples, but your not going to keep on increasing the price if you dont have anybody to sell to.
ppl will reduce their spending levels, so already there are less ppl buying. if you keep increase your prices, even less ppl will buy, so at some point you're gnna have to reduce the level of your prices.

in this way the interest rates are actually used to keep a check on price levels.

hope that helps