Wednesday, October 08, 2008

INFLATION GONE WILD!!

July 20, 2008

This is not funny, anymore.

Zimbabwe’s central bank recently issued $100 Billion banknotes in a desperate bid to ease the recurrent cash shortages plaguing the inflation-ravaged economy. The 100B$ bill still can’t buy a loaf of bread, but can instead buy only four oranges. It’s equal to just one U.S. dollar!!! Zimbabwe has seen an vicious economic meltdown since its independence in 1980, with the official inflation rate now at a staggering 2.2 million percent.

IMPACT OF INTEREST RATES ON INFLATION:

Changes in Federal interest rates influences interest rates charged for overdrafts, mortgages, loans and savings accounts. This change then affects the price of financial assets such as bonds and shares as well as the exchange rate of the currency. This in turn affects the consumer and business demand and thereby the output. This then impacts the employment levels and wage costs - which finally influence producer and consumer prices and thus the CPI and PPI.

Contributors:

  • A change in interest rates changes the cost of borrowing and thereby affects spending decisions. Interest rates impact the attractiveness of spending today versus spending tomorrow, as mentioned earlier. An increase in interest rates makes saving more attractive and borrowing less, which reduces spending, by both consumers and producers. Conversely, a reduction in interest rates increases spending by both consumers and producers.

  • A change in interest rates impacts consumers’ and producers’ cash flow or the amount of cash at hand. For savers, a rise in interest rates increases the money received from interest on their saving. But it will also imply higher interest payments for those with loans as they end up paying variable interest rates (as opposed to fixed rates which do not change). These fluctuations in cash flow affect spending.

  • A change in interest rates affects the value of certain investments, such as homes and stocks. Higher interest rates increases the return on savings, thereby encouraging people to invest less in property and stocks. A fall in demand for these reduces their prices, thereby eroding the wealth of investors. This, in turn, influences them to spend less.

  • A rise in interest rates in the US relative to other countries increases the amount of funds flowing into the US, as investors are attracted to the returns on a higher dollar rate of interest. This appreciates the exchange rate of the dollar against other currencies. In reality, the exchange rate is set by expectations about future interest rates and any unexpected changes in interest rates, as when investors expect interest rates to rise, they increase the amount they invest in a currency before interest rates actually rise. An increase in the value of the $ reduces the price of imports and, because many imported goods are included in the CPI, this has a direct influence on inflation. Also, a stronger dollar reduces the global demand for US goods and services. This reduces the exports which then reduces the output, and shifts domestic spending to imported goods.
  • Read more: Inflation vs. Interest Rates