I think I understand how low interest rates cause inflation.
But do high rates just stop inflation from continuing, or do they somehow turn back the clock and cause deflation?
As always, links are appreciated.
I guess that if central banks establish an interest rate above the natural one, what is going to happen is that simply banks will stop borrowing money from that central bank.
So I don’t think that would cause deflation, but I might be wrong.
You’ve got it backwards. The expansion of the money supply causes interest rates to drop, not the other way around.
It helps to remember that the Fed doesnt ‘control’ the interest rate directly(except for the discount rate it directly loans to banks at). Rather the Fed buys/sells Government bonds in order to lower/raise the amount of excess reserves banks have on hand, that is the money banks loan out.
If banks have more excess reserves, they’ll lower interest rates to encourage more people to borrow from them. If they have less then they’ll raise interest rates to discourage borrowers.
So when the Fed is ‘raising interest rates’ what they are really doing is selling Government bonds to banks in order to take some of the money in bank vaults out of circulation. And banks will raise their interest rates as a result of not having as much money on hand to loan out.
uh oh, I see I have a lot to learn here. Thanks guys.
"I think I understand how low interest rates cause inflation.
But do high rates just stop inflation from continuing, or do they somehow turn back the clock and cause deflation?"
Interest rates are influenced/targeted, not set. So the Fed buys assets (prints money) from the banks which gives the banks more in reserves thus increasing the supply of loanable funds, pushing the interest rate lower. If inflation is expected (due to the increase in the money supply) then nominal interest rates will have a tendency to rise to offset the loss in purchasing power.
If the Fed wants to raise interest rates (we’ll assume the demand for loans stays the same), it can do so by lessening the supply of reserves by selling assets like treasury bills to the banks (less loanable funds, higher interest rate). If people expect this to be deflationary (smaller money supply), nominal interest rates will fall to offset the increase in purchasing power.
However it’s important to note that the Fed funds rate is the interest rate banks charge each other for relatively short term loans. So if the loan is only for a month and the expected CPI for that year will increase 5%, the bank will only charge for what it expects the inflation rate for that month to be (which is probably negligible as it would be less than half a percent assuming all months experience the same inflation rate). So inflationary/deflationary expectations don’t play much of a role in very short term loans.
“I think I understand how low interest rates cause inflation.”
I don’t think that low interest rates do cause inflation. Inflation is caused by governments “printing” more money.
Printing money and the resulting inflation is one way governments can get money to spend on themselves and their supporters. The other two ways are to tax (rob), or to get some sucker to lend them the money that they never fully repay (borrowing via bonds or T-Bills).
Increasing interest rates to stop inflation is government double speak that they use when the public has cottoned to the fact that they are printing money and inflating. Raising interest rates really allows governments to use the borrowing money ruse to gain money instead.
“But do high rates just stop inflation from continuing, or do they somehow turn back the clock and cause deflation?”
No. High interest rates just allow govenments to raise money in a different way from printing money.