4 ms·

Macroeconomics novice here. What's the argument that interest rates need to be close to inflation rates to counteract it? It seems like there should be an intr

Macroeconomics novice here. What's the argument that interest rates need to be close to inflation rates to counteract it? It seems like there should be an intrinsic time-value of money (e.g. 1 stuff today is worth 1.05 stuff next year) which is tradable (supply of future-stuff will equal demand for future-stuff at some rate like 1.05). And that single rate of stuff-interest would exist if the central bank does nothing. If that's true, then in a long-run equilibrium, shouldn't there be zero inflation if the interest rate in dollars (i.e. the fed rate) matches that intrinsic rate of stuff-interest? Any explanation or links to the same would be helpful! I'm just past the point of grasping the fact that interest rates going down causes inflation to go up, but finding it hard to find sources on anything that give me intuition on answering e.g. how much things would go up if you held one policy forever, and what factors that answer would depend on.

edgyquant 4y ago
Interest rates are risk free premiums. If inflation is less than them they are profitable this people move their capital into “risk free assets” like bonds, loans etc that are based on that rate. If the risk free rate is less than the inflation rate then people move their cash into higher risk assets like stocks otherwise they lose out to inflation in the long run. This is said to kick start the economy etc.
- mdcds 4y ago
  Which people? Def not mom-and-pop investors who use pension funds and wealth managers/advisors to keep their investments in (usually) diversified portfolios.
  - edgyquant 4y ago
    Those mom an pops own ETFs and index funds which definitely allocate for risk based on interest rates and inflation.
mdcds 4y ago
I had the same question! The mechanism of higher rates reducing inflation isn't clear to me. Does it go down because people with cash choose to park it and earn interest instead of buying goods and services? Or does it go down because higher interest rates make the cost of doing business more expensive which leads to reduction in overall business activity? If it's by reducing business activity, then seems like the "breaking point" can be at any arbitrary interest rate for a given country in a given year. Also, if inflation is caused by the lack of supply (like the supply chain issues / chip shortage and such), then I think reducing business activity will only exacerbate the problem by reducing the supply further (and I don't hear anyone explore this angle).
- lupire 4y ago
  You can't increase supply by lowering rates if there is a real shortage of inputs, as caused by Covid. Printing money (lowering rates) only helps if there is potential capacity (idle people and resources, and cash-poor-demand) that need a jump start to find each other and "combust" to create value.
- imtringued 4y ago
  The economy is always deflationary because the way we create money also creates an obligation to return and destroy money so given enough time, the money supply trends towards zero no matter what you do. A higher interest rate makes it less appealing to take on a loan, which means repayment outweighs new loans which results in a net reduction in the money supply. Here is the dirty secret, you could have done the same thing by limiting reserves and increasing the reserve requirements without raising the interest rate. This is a long term effect that you can in theory do forever until your economy suffers from deflation and actually needs lower interest rates, possibly negative, to shrink the money supply. Another reason is that a high enough interest rate makes people sell their risky assets and hold more money until the risk adjusted return on money and risky investments is the same. The latter is a short term effect that actually goes away eventually as paying a 70% interest rate makes the debt problem worse and necessitates even more debt just to pay the ridiculous interest rate.

edgyquant 4y ago

Interest rates are risk free premiums. If inflation is less than them they are profitable this people move their capital into “risk free assets” like bonds, loans etc that are based on that rate. If the risk free rate is less than the inflation rate then people move their cash into higher risk assets like stocks otherwise they lose out to inflation in the long run. This is said to kick start the economy etc.

mdcds 4y ago
Which people? Def not mom-and-pop investors who use pension funds and wealth managers/advisors to keep their investments in (usually) diversified portfolios.
- edgyquant 4y ago
  Those mom an pops own ETFs and index funds which definitely allocate for risk based on interest rates and inflation.

mdcds 4y ago

I had the same question! The mechanism of higher rates reducing inflation isn't clear to me. Does it go down because people with cash choose to park it and earn interest instead of buying goods and services? Or does it go down because higher interest rates make the cost of doing business more expensive which leads to reduction in overall business activity? If it's by reducing business activity, then seems like the "breaking point" can be at any arbitrary interest rate for a given country in a given year. Also, if inflation is caused by the lack of supply (like the supply chain issues / chip shortage and such), then I think reducing business activity will only exacerbate the problem by reducing the supply further (and I don't hear anyone explore this angle).

lupire 4y ago
You can't increase supply by lowering rates if there is a real shortage of inputs, as caused by Covid. Printing money (lowering rates) only helps if there is potential capacity (idle people and resources, and cash-poor-demand) that need a jump start to find each other and "combust" to create value.
imtringued 4y ago
The economy is always deflationary because the way we create money also creates an obligation to return and destroy money so given enough time, the money supply trends towards zero no matter what you do. A higher interest rate makes it less appealing to take on a loan, which means repayment outweighs new loans which results in a net reduction in the money supply. Here is the dirty secret, you could have done the same thing by limiting reserves and increasing the reserve requirements without raising the interest rate. This is a long term effect that you can in theory do forever until your economy suffers from deflation and actually needs lower interest rates, possibly negative, to shrink the money supply. Another reason is that a high enough interest rate makes people sell their risky assets and hold more money until the risk adjusted return on money and risky investments is the same. The latter is a short term effect that actually goes away eventually as paying a 70% interest rate makes the debt problem worse and necessitates even more debt just to pay the ridiculous interest rate.