What is the relationship between inflation and interest rates?

The relationship between inflation and interest rates is primarily influenced by the actions of central banks and the expectations of future economic conditions. Higher inflation typically results in higher interest rates because central banks, such as the Federal Reserve, often increase interest rates in response to rising inflation to help control it. When inflation is high, it diminishes the purchasing power of money, prompting banks to charge higher interest rates to compensate for the reduced value of future payments.

This relationship is driven by the need to maintain price stability and manage economic growth. By raising interest rates, borrowing becomes more expensive and, as a result, spending and investment may decrease, which can help cool off an overheating economy and reduce inflationary pressure. Conversely, when inflation rates are low, there is less pressure on central banks to raise interest rates, resulting in a more favorable borrowing environment.

Understanding this dynamic is crucial for comprehending monetary policy and its effects on the economy. Economic agents, such as businesses and consumers, closely watch these interest rate changes as they impact decisions regarding borrowing, investing, and spending.