Mortgage Basics

The Relationship Between Inflation And Interest Rates

The Relationship Between Inflation And Interest Rates
Written by
  • Ashley Howard
| 12 June 2023
Reviewed, 2 August 2023
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    Inflation is a hot topic in Canada, especially regarding the economy. One of the most essential aspects of inflation affecting Canadians is its relationship with interest rates. Understanding how these two forces interact can be invaluable for investing or borrowing money. In this post, we’ll look at inflation and interest rates, their correlation, and their effect on our finances.

    Key Takeaways

    • Inflation is the increase in prices and the decrease in purchasing power of a currency.
    • Central banks can increase interest rates to slow inflation or decrease interest rates to encourage economic growth.
    • Policymakers must carefully consider the impacts of interest rates on inflation to maintain a stable and healthy economy.

    Definition Of Inflation

    Inflation is a term used to describe the general increase in prices and the resulting decrease in purchasing power of a currency. This occurs when the demand for goods and services surpasses the supply or when there is an increase in the supply of money without a proportional increase in the supply of goods and services. 

    High inflation levels can negatively affect the Canadian economy, reducing the value of savings and decreasing consumer spending. Understanding how inflation works is essential to macroeconomics (the study of whole economies). This helps policymakers implement measures to stabilize economies and ensure sustainable growth.

    Definition Of Interest Rates

    Interest rates are a crucial part of the economy, affecting everything from mortgages to credit cards to car loans. Simply put, an interest rate is a fee a lender charges as a percentage of the funds borrowed over a set period of time. 

    Higher interest rates mean borrowing money is more expensive, while lower rates make it cheaper. Interest rates can vary greatly depending on the type of loan and the lender’s risk assessment of the borrower. 

    Banks and other financial institutions set interest rates based on various factors, including the borrower’s creditworthiness, the loan length, and the current state of the economy. 

    Overview Of The Relationship Between Inflation And Interest Rates

    Inflation and interest rates have a complex and complementary relationship that affects individuals and the broader economy. Inflation is the sustained increase in the price of goods and services over time. Meanwhile, interest rates are the cost of borrowing for the borrower or the return on investment (ROI) for the investor/lender. 

    Central banks often increase interest rates when inflation rises to slow down consumer spending and reduce pressure on prices by motivating people to build up savings. Conversely, when inflation is low, interest rates may decrease, making borrowing more affordable and encouraging economic growth through investing. 

    These policies can significantly impact economic indicators, including employment, investments, and a country’s gross debt product (GDP). These dynamics create an intricate relationship between inflation and interest rates, influencing factors like how much interest you pay on a car loan and the percentage of return you may receive on your investments. 

    How Does Inflation Impact Interest Rates?

    Inflation is a key determinant of short and long-term economic stability and directly influences how much interest you pay. Inflation is an important economic indicator that impacts the interest rates associated with mortgages and other loan products.

    The Effect Of Increasing Inflation On Interest Rates

    Inflation can significantly affect the economy, particularly interest rates. As inflation increases, it can cause the purchasing power of money to decrease, leading to higher prices for goods and services. 

    When inflation increases, it erodes money’s purchasing power. In response, central banks may increase interest rates to curb inflation by discouraging borrowing while encouraging savings, thus reducing demand for goods and services and lowering prices. 

    It’s worth noting that while increasing interest rates can help control inflation, it is meant to slow economic growth and increase unemployment. As such, finding the right balance between inflation and interest rates is critical for central banks.

    The Effect Of Decreasing Inflation On Interest Rates

    When inflation rates decrease, it often also impacts interest rates. The relationship between inflation and interest rates is correlated, meaning as inflation decreases, interest rates also tend to decrease. 

    When inflation is lowered, the purchasing power of each dollar increases, reducing the need for lenders to charge a higher interest rate to compensate for inflation. 

    Additionally, as interest rates decrease, it can stimulate economic growth by making borrowing more affordable for consumers and businesses. The relationship between inflation and interest rates is sometimes linear when personal factors come into play, such as the risk and location of your property, which may limit the number of lenders who can offer you a mortgage. 

    How Do Interest Rates Impact Inflation?

    Interest rates are a powerful monetary tool that can have a variety of effects on the economy, including inflation. It is vital for policymakers to carefully consider the impact of interest rates on inflation and take appropriate measures to maintain a stable and healthy economy by maintaining a balance between the two.

    The Effect Of Increasing Interest Rates On Inflation

    Interest rates play a considerable role in controlling the economy and inflation. Increasing interest rates is known to lessen inflation. By increasing the cost of borrowing, interest rates discourage spending and borrowing for individuals and businesses, reducing the market demand for goods and services. Coincidently, it’ll have the opposite effect and encourage people to save due to the higher interest rate on their savings.

    As spending and borrowing are reduced over time, leading to a decrease in inflation. However, while increasing interest rates can be beneficial in reducing inflation, they can also adversely affect the economy by reducing employment and economic growth.

    The Effect Of Decreasing Interest Rates On Inflation

    When central banks decrease interest rates, they hope to incentivize businesses and individuals to borrow and, in turn, stimulate the economy. However, this tactic can also have an impact on inflation. Lower interest rates can make borrowing cheaper, increasing demand for loans and the amount of money flowing through the economy. 

    When interest rates decrease, it becomes easier to borrow money, stimulating economic growth as businesses and individuals are encouraged to spend more of it. As a result, this increased spending can spur consumer spending, increasing prices and potentially leading to inflation, thus completing the economic cycle of tightening and loosening monetary policies. 

    Frequently Asked Questions

    What is inflation?

    Inflation is a general increase in the price of goods and services, resulting in a decrease in the purchasing power of money.

    What are interest rates?

    Interest rates refer to the fee lenders charge borrowers for borrowing money over a certain period of time.

    How does inflation impact interest rates?

    Inflation’s impact on interest rates can be both positive and negative. When inflation increases, it prompts central banks to increase interest rates to compensate for decreased purchasing power. On the other hand, when inflation decreases, it leads central banks to decrease interest rates.

    Final Thoughts

    Central banks, such as the Bank of Canada and the US Federal Reserve,  must balance controlling inflation and managing interest rates. Higher interest rates make borrowing money more expensive, curbing inflation. Conversely, if interest rates increase too quickly or sharply, this can stunt economic growth or push the economy into a recession. Monetary policymakers must carefully consider the impacts of raising or lowering interest rates on inflation and economic growth to stabilize the economy. 

    How could inflationary pressures sticking around longer hamper your home purchase plans? Reach out to our mortgage experts to help you compare and save.