Relationship between Inflation and Interest Rate Essay

Interest and inflation are key to investing decisions, since they have a direct impact on the investment yield. When prices rise, the same unit of a currency is able to buy less. A sustained deterioration in the purchasing power of money is called inflation. Investors aim to preserve the value of their money by opting for investments that generate yields higher than the rate of inflation. In most developed economies, banks try to keep the interest rates on savings accounts equal to the inflation rate. However, when the inflation rate rises, companies or governments issuing debt instruments would need to lure investors with a higher interest rate. The Relationship between Interest and Inflation Inflation is an autonomous occurrence that is impacted by money supply in an economy. Central governments use the interest rate to control money supply and, consequently, the inflation rate. When interest rates are high, it becomes more expensive to borrow money and savings become attractive. When interest rates are low, banks are able to lend more, resulting in an increased supply of money. Alteration in the rate of interest can be used to control inflation by controlling the supply of money in the following ways: †¢A high interest rate influences spending patterns and shifts consumers and businesses from borrowing to saving mode. This influences money supply. †¢A rise in interest rates boosts the return on savings in building societies and banks. Low interest rates encourage investments in shares. Thus, the rate of interest can impact the holding of particular assets. †¢A rise in the interest rate in a particular country fuels the inflow of funds. Investors with funds in other countries now see investment in this country as a more profitable option than before. Inflation and Interest Rates: Effect on the Time Value of Money Inflation has a significant impact on the time value of money (TVM). Changes in the inflation rate (whether anticipated or actual) result in changes in the rates of interest. Banks and companies anticipate the erosion of the value of money due to inflation over the term of the debt instruments they offer. To compensate for this loss, they increase the interest rates. The central bank of a country alters interest rates with the broader purpose of stabilizing the national economy.  Investors need to keep a close watch on interest and inflation to ensure that the value of their money increases over tim e.