One of the key objectives of monetary policy is to maintain price stability defined as keeping inflation low and stable. In general increases in interest rates lead to higher borrowing costs and therefore less spending and economic activity. This reduction in demand can help to cool inflationary pressures.
When inflation is low and stable businesses and households can make spending and investment decisions with greater confidence leading to higher economic growth and higher living standards.
The Reserve Bank sets the official cash rate (OCR) to achieve its inflation target. The OCR influences short-term interest rates such as the rates banks charge on home loans and business loans. Higher interest rates make it more expensive to borrow which reduces spending and economic activity. This can help to cool inflationary pressures.
The OCR is just one of the tools the Reserve Bank uses to influence inflation. Others include:
– The size of the government’s budget deficit or surplus
– The level of government debt
– The exchange rate
– The terms of trade
The link between interest rates and inflation is not always straightforward. For example higher interest rates may lead to higher exchange rates which can offset the cooling effect on inflation.
In the end the Reserve Bank’s objective is to keep inflation low and stable. This is good for the economy and for households and businesses.
What is inflation?
A sustained increase in the general price level of goods and services in an economy.
What is the relationship between inflation and interest rates?
When inflation is high interest rates are typically high as well.
How does an increase in interest rates decrease inflation?
When interest rates rise it becomes more expensive to borrow money.
This can lead to a decrease in spending which can help to slow the economy and reduce inflation.
What is the Federal Reserve’s role in inflation?
The Federal Reserve can influence inflation by raising and lowering interest rates.
What are the effects of inflation?
Inflation can cause the cost of living to increase which can lead to a decrease in the purchasing power of consumers.
Inflation can also lead to higher interest rates and increased borrowing costs.
How is inflation measured?
Inflation is typically measured by the Consumer Price Index (CPI).
What is the CPI?
The Consumer Price Index is a measure of the average price level of a basket of goods and services.
What is the relationship between the CPI and inflation?
The CPI is a measure of inflation.
What are the causes of inflation?
Inflation can be caused by an increase in demand an increase in the money supply or a decrease in supply.
What is the difference between demand-pull inflation and cost-push inflation?
Demand-pull inflation occurs when there is an increase in demand that exceeds the economy’s production capacity.
Cost-push inflation occurs when there is an increase in the cost of inputs that results in an increase in the price of goods and services.
What are the effects of demand-pull inflation?
Demand-pull inflation can lead to higher interest rates and increased borrowing costs.
It can also lead to a decrease in the purchasing power of consumers.
What are the effects of cost-push inflation?
Cost-push inflation can lead to an increase in the cost of living which can reduce the purchasing power of consumers.
It can also lead to higher interest rates and increased borrowing costs.
What is the difference between deflation and inflation?
Deflation is a decrease in the general price level of goods and services while inflation is an increase in the general price level of goods and services.
What are the effects of deflation?
Deflation can lead to a decrease in demand as consumers expect prices to fall in the future.
This can lead to a decrease in production and an increase in unemployment.
What are the causes of deflation?
Deflation can be caused by a decrease in demand a decrease in the money supply or an increase in supply.
