Comment by mdcds | Hacker News Reader

Comment by mdcds | Hacker News Reader

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I had the same question!

The mechanism of higher rates reducing inflation isn't clear to me.

Does it go down because people with cash choose to park it and earn interest instead of buying goods and services? Or does it go down because higher interest rates make the cost of doing business more expensive which leads to reduction in overall business activity?

If it's by reducing business activity, then seems like the "breaking point" can be at any arbitrary interest rate for a given country in a given year.

Also, if inflation is caused by the lack of supply (like the supply chain issues / chip shortage and such), then I think reducing business activity will only exacerbate the problem by reducing the supply further (and I don't hear anyone explore this angle).

The economy is always deflationary because the way we create money also creates an obligation to return and destroy money so given enough time, the money supply trends towards zero no matter what you do. A higher interest rate makes it less appealing to take on a loan, which means repayment outweighs new loans which results in a net reduction in the money supply. Here is the dirty secret, you could have done the same thing by limiting reserves and increasing the reserve requirements without raising the interest rate. This is a long term effect that you can in theory do forever until your economy suffers from deflation and actually needs lower interest rates, possibly negative, to shrink the money supply.

Another reason is that a high enough interest rate makes people sell their risky assets and hold more money until the risk adjusted return on money and risky investments is the same. The latter is a short term effect that actually goes away eventually as paying a 70% interest rate makes the debt problem worse and necessitates even more debt just to pay the ridiculous interest rate.

You can't increase supply by lowering rates if there is a real shortage of inputs, as caused by Covid. Printing money (lowering rates) only helps if there is potential capacity (idle people and resources, and cash-poor-demand) that need a jump start to find each other and "combust" to create value.

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