Yusra3
VIP Contributor
With inflation surging to 40-year highs in 2022, the Federal Reserve has aggressively raised interest rates in hopes of cooling the economy and reining in prices. Here is how higher interest rates aim to curb inflation:
Reducing Consumer Spending
Higher interest rates make borrowing more expensive for consumers and businesses. Rates on credit cards, auto loans and mortgages increase. This reduces spending power and forces cutbacks which should lower aggregate demand. Less demand equals less inflation pressure.
Discouraging Business Investment
Businesses also borrow to invest and expand. As interest rates rise, taking out loans to hire more employees, buy equipment or open new locations becomes costlier. This slows growth and capacity, rebalancing supply and demand.
Increasing Savings
When interest rates on savings accounts, CDs and bonds go up, they become more attractive to consumers. This incentivizes saving over spending. Keeping money in the bank reduces demand for goods and services.
Strengthening the Dollar
As U.S. interest rates rise, dollar-denominated financial assets look more appealing relative to those in foreign currencies. This increases demand for the dollar, making imported goods less expensive for Americans.
Fighting Wage-Price Spiral
Workers tend to demand higher wages during inflationary periods to offset rising costs. This leads to a vicious cycle of businesses raising prices more to afford wage hikes. Slowing the economy eases pressure on this wage-price spiral.
The combined effects of constrained spending among consumers and businesses, more saving and a stronger dollar aim to soften economic growth just enough to stabilize inflated prices without severely impacting employment. Getting the balance right is the Fed’s difficult task.
Reducing Consumer Spending
Higher interest rates make borrowing more expensive for consumers and businesses. Rates on credit cards, auto loans and mortgages increase. This reduces spending power and forces cutbacks which should lower aggregate demand. Less demand equals less inflation pressure.
Discouraging Business Investment
Businesses also borrow to invest and expand. As interest rates rise, taking out loans to hire more employees, buy equipment or open new locations becomes costlier. This slows growth and capacity, rebalancing supply and demand.
Increasing Savings
When interest rates on savings accounts, CDs and bonds go up, they become more attractive to consumers. This incentivizes saving over spending. Keeping money in the bank reduces demand for goods and services.
Strengthening the Dollar
As U.S. interest rates rise, dollar-denominated financial assets look more appealing relative to those in foreign currencies. This increases demand for the dollar, making imported goods less expensive for Americans.
Fighting Wage-Price Spiral
Workers tend to demand higher wages during inflationary periods to offset rising costs. This leads to a vicious cycle of businesses raising prices more to afford wage hikes. Slowing the economy eases pressure on this wage-price spiral.
The combined effects of constrained spending among consumers and businesses, more saving and a stronger dollar aim to soften economic growth just enough to stabilize inflated prices without severely impacting employment. Getting the balance right is the Fed’s difficult task.
