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Can someone explain to me how raising interest rates combats inflation? Doesn't it do the opposite? If rates go up, financing becomes more expensive, meaning I'

• robjan 4y ago
  Borrowing becomes more expensive so it reduces the amount of cash sloshing around.
  • clownpepe 4y ago
    Just to clarify for the rest; the borrower (ECB) is literally printing new money every time they give out a loan.
    • karatinversion 4y ago
      The ECB is printing money to give out loans to itself?
      • StanislavPetrov 4y ago
        Every central bank does. If you think the ECB is bad, take a look at Japan. Unfortunately the entire "global financial system" is based on this. But don't call it a ponzi scheme or Serious Economists will tell you why it is totally sustainable.
        • afiori 4y ago
          It cannot be a Ponzi scheme; if it can print unbounded amount of money there can be no risk f money running out.
      • everforward 4y ago
        "Literally" was probably an exaggeration, but they are in a way. If you deposit $100 with bank A, and they give a loan for $80 to person B, you have $100 to spend and person B has $80, so $180 can float through the economy. The $80 debt should cancel out person B's surplus, but it kind of doesn't if interest rates are low enough because they'll never actually pay it back. That's my potentially poor understanding of it.
        • karatinversion 4y ago
          Where does the ECB, which doesn’t give loans to individuals, come into it?
          • clownpepe 4y ago
            ECB loans out money to certified banks. This loaned money is “printed” or created on their ledger so to speak
• mamonster 4y ago
  In financial markets its pretty simple: When you raise interest rates, you increase the denominator in the DCF calculation, so most assets are repriced downward.
  • karatinversion 4y ago
    But asset prices aren’t included in inflation indices…
    • makomk 4y ago
      Yeah, the decrease in asset prices is just an unavoidable side effect (and similiarly, the increase in asset prices under the previous low-interest, low-inflation environment was a side effect of attempts to boost inflation and the real economy, not some large scale plot to transfer money to the super wealthy as is often claimed).
• swamp40 4y ago
  I've always had this cognitive dissonance as well. Especially the link between rising interest rates and lowered food prices. I always ask and get ignored. I suspect it's because that's all they can really do. They are a one trick pony.
  • karatinversion 4y ago
    There used to be a joke that the model was raise interest rates -> construction projects become unprofitable and get cancelled -> construction workers cannot afford food, reducing demand -> lower prices
  • rightbyte 4y ago
    Ye it is all baloney. Higher rates gives more money to those with piles of money. Low interest rates does the same but in form of loans. Neither sounds like they decrease inflation.
  • Rury 4y ago
    Think about it like this. A lot of things are financed via credit/debt. For example, you buy a house, using a mortgage, which has an interest rate. Some people might be able to finance a $500k house, at 0% interest rate for 30 years. However, with certainty there are fewer people who are able to finance a $500k house, at 10% interest rate for 30 years, as this costs much more. This means, as interest rates rise, fewer people will be able to secure and offer $500k for a house. As fewer people are offering $500k for a house, sellers will struggle more to sell a house for $500k, and eventually, there even comes a point where prices are forced to drop. As for how high interest rates need to get and how long they are in place to cause a decrease in prices, is mostly a guessing game, but eventually it will cause an effect. Now, that said, initially people might try to raise their prices to offset the increase in financing costs, (and therefore adding to inflation like the parent post thought), but like I said, eventually there comes a point where they just won't find anyone who will buy their higher prices, because no one can afford those higher prices, and therefore prices must come down if transactions are to continue happening at all, and some transactions will surely continue to happen, as some money is better than no money, when you got a liability to pay. And this also applies to food prices, along with most everything, in very similar but indirectly complex ways, mainly because most transactions in the economy happen via credit, then with actual money/cash. Let alone the fact that all money originates via central bank loans.
• taylodl 4y ago
  Here's the theory. The economy is "too hot", there's too much money circulating, and as a result demand increases which drives up prices. By making money more expensive, by raising interest rates, that money is taken out of circulation because it's more expensive and demand decreases which drives down prices. That's how things work in a normal market. Bottom line: economy is too "hot", i.e. high inflation, you raise rates. If you want to "juice" the economy then you lower rates.
• karatinversion 4y ago
  The phrase to search is “transmission mechanism of monetary policy”, but generally, your customers’ financing is also more expensive, so they can afford less at current prices, let alone higher ones. Reduced income and increase expense means you cancel investments and lay off staff. The reduced demand for investment goods and workers means less upward pressure on prices.
• LittleNemoInS 4y ago
  Inflation occurs when demand is greater than production. This means there is too much cash flowing around. By raising interest rates, you tighten the cash flow : It's harder to get cash from the banks, thus the demand will diminish, and the prices will lower.
• vkou 4y ago
  > Can someone explain to me how raising interest rates combats inflation? ELI5: Inflation is directly proportional to the money supply. The more money is circulating, the more things cost. Money supply is inversely proportional to interest rates. If I could borrow at 0% APR, I will happily borrow a trillion dollars, even if I had no idea what to do with it. And now the important thing: In modern economies, when people borrow money, that money is magically created out of thin air and added to the money supply. This means that when interest rates drop, money supply goes up, and inflation goes up. When interest rates rise, money supply goes down, and inflation goes down. There's a lag to these effects, and there's a limit to how much interest rates can affect inflation, and there are other factors at play, but this is the bare bones of it.
• MichaelRazum 4y ago
  Sure, there are some effects that come to play. - Lets say you have a lot of euro. Interest rate is 0 and the US interest rate is 2%. Then you might think of selling euro and buy dollar to get the 2%. Especially if you think that euro/usd will decline further. - Now let's say your interest rate is even higher now at 10%. A lot of houses in Germany produces something like 3% yearly revenue. So now you might start selling the houses with the same argument, since you could get 10% risk free compared to 3%. Housing prices go down, if you can't raise the rent.. Same effect on business that are doing just small revenue compared to the capital. It doesn't make sense to operate them. They quit -> consume less resources. - Other effects like people spend less since saving becomes a bit more interesting. Firm's invest less, since the investment has to beat the interest rate. PS: All that leads to a stronger currency. So your imports become cheaper and that helps a lot to fight inflation.