Can someone explain to me how raising interest rates combats inflation? Doesn't it do the opposite? If rates go up, financing becomes more expensive, meaning I'll need more money to do business, meaning I'll have to raise my prices to match?
If you deposit $100 with bank A, and they give a loan for $80 to person B, you have $100 to spend and person B has $80, so $180 can float through the economy.
The $80 debt should cancel out person B's surplus, but it kind of doesn't if interest rates are low enough because they'll never actually pay it back.
That's my potentially poor understanding of it.
ELI5:
Inflation is directly proportional to the money supply. The more money is circulating, the more things cost.
Money supply is inversely proportional to interest rates. If I could borrow at 0% APR, I will happily borrow a trillion dollars, even if I had no idea what to do with it.
And now the important thing: In modern economies, when people borrow money, that money is magically created out of thin air and added to the money supply.
This means that when interest rates drop, money supply goes up, and inflation goes up.
When interest rates rise, money supply goes down, and inflation goes down.
There's a lag to these effects, and there's a limit to how much interest rates can affect inflation, and there are other factors at play, but this is the bare bones of it.
- Lets say you have a lot of euro. Interest rate is 0 and the US interest rate is 2%. Then you might think of selling euro and buy dollar to get the 2%. Especially if you think that euro/usd will decline further.
- Now let's say your interest rate is even higher now at 10%. A lot of houses in Germany produces something like 3% yearly revenue. So now you might start selling the houses with the same argument, since you could get 10% risk free compared to 3%. Housing prices go down, if you can't raise the rent.. Same effect on business that are doing just small revenue compared to the capital. It doesn't make sense to operate them. They quit -> consume less resources.
- Other effects like people spend less since saving becomes a bit more interesting. Firm's invest less, since the investment has to beat the interest rate.
PS: All that leads to a stronger currency. So your imports become cheaper and that helps a lot to fight inflation.
I suspect it's because that's all they can really do. They are a one trick pony.
Neither sounds like they decrease inflation.
Some people might be able to finance a $500k house, at 0% interest rate for 30 years. However, with certainty there are fewer people who are able to finance a $500k house, at 10% interest rate for 30 years, as this costs much more. This means, as interest rates rise, fewer people will be able to secure and offer $500k for a house. As fewer people are offering $500k for a house, sellers will struggle more to sell a house for $500k, and eventually, there even comes a point where prices are forced to drop. As for how high interest rates need to get and how long they are in place to cause a decrease in prices, is mostly a guessing game, but eventually it will cause an effect.
Now, that said, initially people might try to raise their prices to offset the increase in financing costs, (and therefore adding to inflation like the parent post thought), but like I said, eventually there comes a point where they just won't find anyone who will buy their higher prices, because no one can afford those higher prices, and therefore prices must come down if transactions are to continue happening at all, and some transactions will surely continue to happen, as some money is better than no money, when you got a liability to pay.
And this also applies to food prices, along with most everything, in very similar but indirectly complex ways, mainly because most transactions in the economy happen via credit, then with actual money/cash. Let alone the fact that all money originates via central bank loans.
I can also see how they can crash any large purchases financed by credit: cars, machinery, etc.
I can see how they can stop growth, how they can crash companies that have overextended.
But I cannot follow how the prices of goods and services come down. I'm not even arguing that they don't come down, I just can't follow the logic.