The relationship between inflation and interest

Real Interest Rates

Real Interest Rate = Nominal Interest Rate - Inflation

Inflation is usually positive. Thus, the real interest rate is usually lower than the nominal interest rate. If we have deflation, the otherwise is true.

Influences on Interest Rates

There are several important relationships that tie inflation, interest rates, bond prices, and stock prices together. First, interest rates over any extended period of time are a function of the inflation rate. Second, bond prices are influenced by interest rates. Third, stock prices are influenced by changes in bond prices, as bonds are competition for stocks.

Inflation and Interest Rates

The most important thing that drives inflation is the amount of money that the government makes available to the economy. If the government makes excess money, the prices of goods and services increase.

This increase in prices causes a loss of purchasing power, which is inflationary. As people know that their purchasing power is decreasing, they want higher wages. These higher wages cause more inflation.

Why is it so important to know real interest rates?

For a start, you might need to know that we will lose money even if we put our savings into a bank because of inflation.

Furthermore, knowledge on real interest rates can help you when you are about to lend money, or borrow money from a bank, so that you can estimate your loss or gain. Interest is also used in credit card bills.