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My layman understanding: raising interest rates is supposed to slow down businesses from growing as fast. The way businesses often respond is by downsizing the

My layman understanding: raising interest rates is supposed to slow down businesses from growing as fast. The way businesses often respond is by downsizing the workforce. So then you get inflation that’s still high + high unemployment: not a great recipe. Does anyone with a background in economics have more insight into this?

andrewljohnson 3y ago
Stagflation is the name for that, it last happened in my country in the 1970s.
barumrho 3y ago
In economics, everything affects everything else, so you are trying to solve for the equilibrium. For example, high unemployment (not the only immediate effect) in turn will reduce consumption either directly due to loss of income or anticipation of it. Traditionally, there is the Phillips Curve which states that unemployment and inflation have inverse relationship. https://en.wikipedia.org/wiki/Phillips_curve https://en.wikipedia.org/wiki/Phillips_curve
seizethecheese 3y ago
Downsizing the workforce leads to lower inflation (fewer people spending money on a supply of goods and services that are relatively fixed in the short run.)
creer 3y ago
Raising interest rates slows business expansion. It limits new investments by making borrowing more expensive - and borrowing is often an ingredient of business expansion. (In the case where inflation was high because businesses were over-ambitious) Businesses downsize the workforce either (1) because they are in difficulty already, (2) or because they expect a contraction in their business and want to be better prepared, (3) or because they now doubt that their earlier bold plans will work out. Raising interest rates is often done too late, too much, and too long - which then starts an economic contraction. A "soft landing" is rare so some businesses take measures in advance of that contraction. But normally interest rate increases are because the economy is expanding too fast (which causes price inflation) - normally that's a low unemployement time. Business response will raise unemployment a little but not much. What WOULD raise unemployement significantly is a contraction because interest rates stayed high too long. An oil shock is a different kind of beast: you get price inflation even though there wasn't excess growth. Still... 42% is a signal things are out of control. At that stage are businesses still borrowing at all? So will this increase have much effect?
roussanoff 3y ago
Short answer: it's complicated. Longer answer: what you are interested in is called the “transmission mechanism”, and the reduced workforce (and also investment by businesses) is only a part of it. The main part of the transmission mechanism is consumption: when interest rates go up, saving becomes more attractive and people shop less, preferring to spend later. They also face lower asset prices (did you notice how all bonds lost value over the past year? that's what it is) and so choose to spend less. The inflation-unemployment trade-off that you mentioned is also a part of it. All economists know that there are trade-offs between policy goals, and you have to make judgement calls about what the society's priorities are. If only the voters could vote on “2% lower inflation compared to now” vs “1 percent lower unemployment compared to now”. For better or for worse, they don't do that.
- zozbot234 3y ago
  The transmission mechanism is not actually via raising interest rates in any real sense, it's by draining money from the economy - selling assets for money, and then retiring that money. This leaves economic actors with lower money balances than they wish to hold at the given level of nominal spending (price level × real activity) which in turn incents them to spend less in all kinds of ways. Which then leads to lower expectations of the future price level (as well as future real activity), which works to reel in the inflationary spiral. Interest rates play little to no role in this specifically, and actually they are a lot more complicated because policy interest rates are set according to a liquidity effect (more money = lower rates) but natural or market rates move according to the Fisher effect (more money = more nominal spending in the future, thus higher interest rates!). Setting policy interest rates for any length of time thus always involves trying to achieve stability in an inerently unstable fashion, akin to balancing an inverted pendulum. It's not worth worrying too much about those.
okl 3y ago
You're right and it is, for example, captured in the Fed's double mandate of price stability and maximum employment: https://www.stlouisfed.org/in-plain-english/the-fed-and-the-dual-mandate https://www.stlouisfed.org/in-plain-english/the-fed-and-the-...
lumost 3y ago
TL;DR this is a complex topic - however at the edge, you can always raise interest rates to the point there is a recession/depression. People will stop buying homes, businesses will stop investing, companies will go bankrupt. Once this process continues for long enough and with sufficient magnitude, inflation will stop - this is effectively what happened in the early 80s in the US. There is always a prevailing interest rate which achieves the goal of stopping inflation. The little understood con of interest rate based management of the economy is how much the economy adapts to the interest rate cycle. There are businesses that are less sensitive to interest rates - and there are businesses which can leverage parts of the cycle to benefit from policy depressed rates. It's not necessarily a good thing for the economy to be structured around a policy tool. Note: Just an interested observer of economics - not a trained economist.
ethbr1 3y ago
Afaik, the intent of raising central bank interest rates is to shrink the effective money supply (forget which M* this is). It does this by raising the interest rate charged on newly originated loans (why loan at less than the central rate you could get for depositing?), which results in fewer loans (low-return opportunities no longer feasible to finance), which decreases the effective money multiple (due to fractional reserves, availableToLoan:deposited ratio). On the one hand, this supports the value per currency unit, as less currency chasing same number of goods. On the other hand, it can decrease net economic activity and blunt its own intent, as you note. At the end of the day though... it's extremely difficult to run a functioning economy with persistently high inflation. See also: Argentina. So, paraphrasing the new Argentinian president's words, 'This needs measures that will make things worse before it gets better.'
AnonHP 3y ago
Another layperson here. Yes, higher unemployment is certainly a possibility. But with higher interest rates, it’s not just businesses that are affected. It’s anyone who needs credit for any purpose (buying a home appliance, buying a home, buying a vehicle, wanting to study at a university that one cannot pay for immediately, etc.). At a fundamental level, the target is consumption and the aim is to reduce it. Inflation is when there’s more money but lesser availability of goods and services that people want. So you either have to increase the production of (or import of) goods and services or reduce the amount of money in circulation. Central banks can only do the latter. The former is the responsibility of the executive and legislature to do with policy measures (short term, medium term, long term) on local and well as the international trade fronts. Coming back to unemployment, it will likely rise. It will have a spiraling effect on other things (people going broke, loans being defaulted, etc.). If you’ve read about all the developed countries targeting high inflation, and in particular what the U.S. Fed has been doing, there’s been a lot of talk about a “smooth landing”, which implies that the interest rate hikes will gradually bring down inflation without causing a big decline in GDP growth and related effects. This is mostly a fantasy because in reality nobody has figured out how to get other people, i.e., an entire population, to do something in unison. While interest rates control ease of access to money, central banks can control the amount of money available through various mechanisms (liquidity control in banks, reserve requirements, etc.). Interest rate increases require time to show up in their effects (several months or quarters). Other measures can have a quicker impact. Businesses, especially larger ones, will have access to bind their effective interest rate to lower values for longer. So these changes won’t show up uniformly everywhere. All said and done, central banks are typically (IMO) powerless in handling inflation or deflation. Without other policy decisions and policy actions (local and international) by the government, there’s not a lot that central banks can do without inflicting too much damage and getting into a whiplash reaction when things spike out of control.
throw0101b 3y ago
> So then you get inflation that’s still high + high unemployment: not a great recipe. Does anyone with a background in economics have more insight into this? * https://en.wikipedia.org/wiki/Stagflation https://en.wikipedia.org/wiki/Stagflation It was not 'supposed' to happen in (original/early) Keynesianism, but it occurred in the 1970s in the US, which led some folks to declare Keynesism dead/invalid. People thought about it and analyzed it some, and by the end of the 1970s models were updated with a better understanding of the mechanisms, and every text since about 1980 goes over the details.
jfengel 3y ago
You've got it. Low interest rates spur the economy by letting companies borrow cheaply to expand their business. That's supposed to combat unemployment, but at a cost of high inflation, since there's more money. So, conversely, you can combat inflation by raising interest rates. But that's only one cause of inflation. If your economy is unproductive, or if the costs of your supplies go up, then prices will go up regardless of what your interest rates are. That was what happened to the US (and elsewhere) in the 1970s. Oil prices skyrocketed, and that raises the price of literally everything. Fewer goods were purchased, so companies reduced staff, raising unemployment. Unemployment + inflation is called the "misery index", and it's not easily fixed just with monetary measures. The US solved that in part by government debt. The government is the "borrower of last resort". It can pump money into the economy even when interest rates are high. That will eventually cause inflation but can also break the cycle of price rises and firings. People buy stuff despite high prices, more workers are hired, and eventually the economy reaches a new equilibrium despite the higher price of supplies.
- surgical_fire 3y ago
  Correct me if I'm wrong, but my layman's understanding is that not all inflation is equal. Raising interest rates is useful to lower inflation when inflation happens on the demand side of things no? By making money more "expensive" it reduces the money in general circulation. Does it also work when the inflation comes from the supply side of things? Like, a war or natural tragedy that causes a certain commodity to spike in price due to low availability?

andrewljohnson 3y ago

Stagflation is the name for that, it last happened in my country in the 1970s.

barumrho 3y ago

In economics, everything affects everything else, so you are trying to solve for the equilibrium. For example, high unemployment (not the only immediate effect) in turn will reduce consumption either directly due to loss of income or anticipation of it. Traditionally, there is the Phillips Curve which states that unemployment and inflation have inverse relationship. https://en.wikipedia.org/wiki/Phillips_curve https://en.wikipedia.org/wiki/Phillips_curve

seizethecheese 3y ago

Downsizing the workforce leads to lower inflation (fewer people spending money on a supply of goods and services that are relatively fixed in the short run.)

creer 3y ago

Raising interest rates slows business expansion. It limits new investments by making borrowing more expensive - and borrowing is often an ingredient of business expansion. (In the case where inflation was high because businesses were over-ambitious) Businesses downsize the workforce either (1) because they are in difficulty already, (2) or because they expect a contraction in their business and want to be better prepared, (3) or because they now doubt that their earlier bold plans will work out. Raising interest rates is often done too late, too much, and too long - which then starts an economic contraction. A "soft landing" is rare so some businesses take measures in advance of that contraction. But normally interest rate increases are because the economy is expanding too fast (which causes price inflation) - normally that's a low unemployement time. Business response will raise unemployment a little but not much. What WOULD raise unemployement significantly is a contraction because interest rates stayed high too long. An oil shock is a different kind of beast: you get price inflation even though there wasn't excess growth. Still... 42% is a signal things are out of control. At that stage are businesses still borrowing at all? So will this increase have much effect?

roussanoff 3y ago

Short answer: it's complicated. Longer answer: what you are interested in is called the “transmission mechanism”, and the reduced workforce (and also investment by businesses) is only a part of it. The main part of the transmission mechanism is consumption: when interest rates go up, saving becomes more attractive and people shop less, preferring to spend later. They also face lower asset prices (did you notice how all bonds lost value over the past year? that's what it is) and so choose to spend less. The inflation-unemployment trade-off that you mentioned is also a part of it. All economists know that there are trade-offs between policy goals, and you have to make judgement calls about what the society's priorities are. If only the voters could vote on “2% lower inflation compared to now” vs “1 percent lower unemployment compared to now”. For better or for worse, they don't do that.

zozbot234 3y ago
The transmission mechanism is not actually via raising interest rates in any real sense, it's by draining money from the economy - selling assets for money, and then retiring that money. This leaves economic actors with lower money balances than they wish to hold at the given level of nominal spending (price level × real activity) which in turn incents them to spend less in all kinds of ways. Which then leads to lower expectations of the future price level (as well as future real activity), which works to reel in the inflationary spiral. Interest rates play little to no role in this specifically, and actually they are a lot more complicated because policy interest rates are set according to a liquidity effect (more money = lower rates) but natural or market rates move according to the Fisher effect (more money = more nominal spending in the future, thus higher interest rates!). Setting policy interest rates for any length of time thus always involves trying to achieve stability in an inerently unstable fashion, akin to balancing an inverted pendulum. It's not worth worrying too much about those.

okl 3y ago

You're right and it is, for example, captured in the Fed's double mandate of price stability and maximum employment: https://www.stlouisfed.org/in-plain-english/the-fed-and-the-dual-mandate https://www.stlouisfed.org/in-plain-english/the-fed-and-the-...

lumost 3y ago

TL;DR this is a complex topic - however at the edge, you can always raise interest rates to the point there is a recession/depression. People will stop buying homes, businesses will stop investing, companies will go bankrupt. Once this process continues for long enough and with sufficient magnitude, inflation will stop - this is effectively what happened in the early 80s in the US. There is always a prevailing interest rate which achieves the goal of stopping inflation. The little understood con of interest rate based management of the economy is how much the economy adapts to the interest rate cycle. There are businesses that are less sensitive to interest rates - and there are businesses which can leverage parts of the cycle to benefit from policy depressed rates. It's not necessarily a good thing for the economy to be structured around a policy tool. Note: Just an interested observer of economics - not a trained economist.

ethbr1 3y ago

Afaik, the intent of raising central bank interest rates is to shrink the effective money supply (forget which M* this is). It does this by raising the interest rate charged on newly originated loans (why loan at less than the central rate you could get for depositing?), which results in fewer loans (low-return opportunities no longer feasible to finance), which decreases the effective money multiple (due to fractional reserves, availableToLoan:deposited ratio). On the one hand, this supports the value per currency unit, as less currency chasing same number of goods. On the other hand, it can decrease net economic activity and blunt its own intent, as you note. At the end of the day though... it's extremely difficult to run a functioning economy with persistently high inflation. See also: Argentina. So, paraphrasing the new Argentinian president's words, 'This needs measures that will make things worse before it gets better.'

AnonHP 3y ago

Another layperson here. Yes, higher unemployment is certainly a possibility. But with higher interest rates, it’s not just businesses that are affected. It’s anyone who needs credit for any purpose (buying a home appliance, buying a home, buying a vehicle, wanting to study at a university that one cannot pay for immediately, etc.). At a fundamental level, the target is consumption and the aim is to reduce it. Inflation is when there’s more money but lesser availability of goods and services that people want. So you either have to increase the production of (or import of) goods and services or reduce the amount of money in circulation. Central banks can only do the latter. The former is the responsibility of the executive and legislature to do with policy measures (short term, medium term, long term) on local and well as the international trade fronts. Coming back to unemployment, it will likely rise. It will have a spiraling effect on other things (people going broke, loans being defaulted, etc.). If you’ve read about all the developed countries targeting high inflation, and in particular what the U.S. Fed has been doing, there’s been a lot of talk about a “smooth landing”, which implies that the interest rate hikes will gradually bring down inflation without causing a big decline in GDP growth and related effects. This is mostly a fantasy because in reality nobody has figured out how to get other people, i.e., an entire population, to do something in unison. While interest rates control ease of access to money, central banks can control the amount of money available through various mechanisms (liquidity control in banks, reserve requirements, etc.). Interest rate increases require time to show up in their effects (several months or quarters). Other measures can have a quicker impact. Businesses, especially larger ones, will have access to bind their effective interest rate to lower values for longer. So these changes won’t show up uniformly everywhere. All said and done, central banks are typically (IMO) powerless in handling inflation or deflation. Without other policy decisions and policy actions (local and international) by the government, there’s not a lot that central banks can do without inflicting too much damage and getting into a whiplash reaction when things spike out of control.

throw0101b 3y ago

> So then you get inflation that’s still high + high unemployment: not a great recipe. Does anyone with a background in economics have more insight into this? * https://en.wikipedia.org/wiki/Stagflation https://en.wikipedia.org/wiki/Stagflation It was not 'supposed' to happen in (original/early) Keynesianism, but it occurred in the 1970s in the US, which led some folks to declare Keynesism dead/invalid. People thought about it and analyzed it some, and by the end of the 1970s models were updated with a better understanding of the mechanisms, and every text since about 1980 goes over the details.

jfengel 3y ago

You've got it. Low interest rates spur the economy by letting companies borrow cheaply to expand their business. That's supposed to combat unemployment, but at a cost of high inflation, since there's more money. So, conversely, you can combat inflation by raising interest rates. But that's only one cause of inflation. If your economy is unproductive, or if the costs of your supplies go up, then prices will go up regardless of what your interest rates are. That was what happened to the US (and elsewhere) in the 1970s. Oil prices skyrocketed, and that raises the price of literally everything. Fewer goods were purchased, so companies reduced staff, raising unemployment. Unemployment + inflation is called the "misery index", and it's not easily fixed just with monetary measures. The US solved that in part by government debt. The government is the "borrower of last resort". It can pump money into the economy even when interest rates are high. That will eventually cause inflation but can also break the cycle of price rises and firings. People buy stuff despite high prices, more workers are hired, and eventually the economy reaches a new equilibrium despite the higher price of supplies.

surgical_fire 3y ago
Correct me if I'm wrong, but my layman's understanding is that not all inflation is equal. Raising interest rates is useful to lower inflation when inflation happens on the demand side of things no? By making money more "expensive" it reduces the money in general circulation. Does it also work when the inflation comes from the supply side of things? Like, a war or natural tragedy that causes a certain commodity to spike in price due to low availability?