The relationship between Interest Rate and Inflation


In order to understand the relationship between interest rate and inflation, we are required to have the basic idea about inflation and bank rate or interest rate.


Inflation:


Inflation can be understood as an economic condition in which the general price level of goods and services in an economy increases. In this regard, it is to be mentioned that the purchasing power of the currency falls if an economy faces the problem of inflation. The supply of money in the economy rises in an inflationary situation and due to this reason, the value of currency decreases in inflation. 


Bank rate or Interest rate:


Central Bank of a country puts control over the monetary system of a country through bank interest rates. This bank rate can be defined as the rate at which the central bank lends money to the commercial banks.


Central Bank of an economy controls the supply of money by various methods, and bank rate is one of the most important tools that facilitate the central banks to manage the quantity of money in the economy. If the bank rate (or Interest rate) of an economy rises, the cost of lending of the commercial banks' increases and due to this reason, commercial banks also enhance the lending rates. As a consequence of this, the cost of debt to the general public (loan takers) rises. Therefore, an enhancement in the bank rate works as a de-motivating factor for taking a loan, as they have to pay higher interest. On this contrary, if the Central Bank decreases the bank rate, the cost of lending becomes less costly, and the people can take the loan from the central bank at a lower rate.




Figure 1: Relationship between Interest rate or Bank Rate and Inflation and Recession 





Therefore, it can be concluded with the note that there exists a circle that forces the Reserve Bank of India to use the interest rate or bank rate as the tool to control the demand in the economy. In this regard, it is to be stated that in order to combat recession in the economy, the Reserve Bank of India decreases the interest rate that results in an enhancement in the aggregate demand in the economy. With this, the quantity of money increases in the economy and that makes the RBI increase the interest rate. This hike creates another recession as a consequence of low demand.





Reference:

Semanticscholar.org