Economics Inflation Questions Medium
The relationship between inflation and the interest rates set by central banks is often referred to as the monetary policy transmission mechanism. Central banks use interest rates as a tool to control inflation and maintain price stability in the economy.
When inflation is high, central banks typically raise interest rates to reduce the money supply and curb spending. By increasing interest rates, borrowing becomes more expensive, which discourages businesses and individuals from taking out loans and spending money. This decrease in spending helps to reduce aggregate demand and ultimately slows down inflationary pressures.
On the other hand, when inflation is low or below the central bank's target, central banks may lower interest rates to stimulate economic activity. Lower interest rates make borrowing cheaper, encouraging businesses and individuals to take out loans and invest in various economic activities. This increase in spending helps to boost aggregate demand and can help to increase inflation towards the central bank's target.
Therefore, the relationship between inflation and interest rates set by central banks is generally inverse. Higher inflation leads to higher interest rates, while lower inflation leads to lower interest rates. Central banks use this relationship to influence the overall level of economic activity and maintain price stability in the economy.