This paper tries to explain the impact of inflation on interest rates (nominal and real interest rates). The impact of inflation on interest rates has usually positive relationship. Higher inflation rates, means higher prices, and more problems for businesses, consumers and government.
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The relationship between the term structure of interest rates, inflation, and real activity has long been recognized as a central to both macroeconomic and finance theory, and as a critical in formulating economic policy and in investment decision (Berardi, 2009). According to Makin (2003a), when inflation is perfectly anticipated these costs, including so called “shoe leather costs” and “menu costs” are thought to be fairly low. However, unanticipated inflation has a more deleterious effect because it arbitrarily redistributes wealth between debtors and creditors. In one of the most influential works on monetary economics, Evans and Wang (2008) suggested a positive relationship between the nominal interest rate and the growth rate of the price level. Moreover, Berument et al (2007) once more confirm the validity of the Fisher hypothesis, which establishes a positive relation between interest rates and expected inflation, for the G7 countries and 45 developing economies. In this literature review, we seek to establish a comprehensive set of information regarding the impact of inflation on interest rates.
This paper is organized as follows. Section I describes the inflation. In section II, we explain the interest rates and its impact on the overall economy. Section III contains the explanations of the impact of inflation on the interest rates, which is the aim of this paper.
Defining the Inflation
Shoven and Bulow (2004) define the inflation as a continual increase in the price level which affects individual, businesses and governments. However, the empirical evidence shows that the predictability of inflation at a long horizon varies considerably across countries and both simple theory and empirical evidence suggest that these differences have been driven by differences in monetary policy (Wright, 2002). Munir at al (2009) state that the conversional view in macroeconomics holds that low inflation is a necessary condition for fostering economic growth. Chi Lo (2009), confirms this by stating that a government debt crisis is rooted in excessive fiscal spending and the economic impact can be either inflationary or deflationary. Money printing boosts demand, forcing the exchange rate to depreciate, and finally causing a debt crisis.
Defining the Interest rates
Interest rates are among most closely watched variables in the economy because their movements directly affect our everyday lives and have important consequences for the health of the economy. Furthermore, they affect personal decision such as whether to consume or save, whether to buy a house, and whether to purchase bonds or put funds into a savings account (Mishkin, 2007a). According to Philipe and Setterfield (2008) interest rates are an important component of economic theory and policy. Moreover, their role and importance are not well understood and although they are used extensively by central bankers to regulate the economy, there does not seem to be a clear grasp of how interest rates actually affect economic variables such as unemployment, inflation, and economic growth. Piga (2005) has provided a formal approach to the argument raised by many authors that delegation of monetary policy into the hands of an independent Central Bank may not be a solution for eliminating the inflation bias in society. There is a difference between nominal and real interest rates according to Bhuiyan and Lucas (2007). Nominal interest rates refer to the rate of interest before adjustment for inflation. While, the real interest rates is the nominal interest rates minus the inflation rate.
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Impact of Inflation on Interest Rates
For several years after the onset of the high inflation in the early 1970s, nominal interest rates remained relatively stable, resulting in real interest rates then turning negative in major economies. After several prior decades of relative price stability, the high inflation regime that emerged in the early 1970s surprised borrowers, including governments running sizeable fiscal deficits (Makin 2003b). When there is a budget deficit, government find ways of financing the deficit through borrowing from commercial and merchant banks or from the non-banking public through the issue of short-term bonds and monetary instruments, A. Isenmila and O. Okolie (2008). Moreover, Besley (2008), a well known professor, argues that most of the countries experienced high and volatile inflation during the 1970s and part of the 1980s, and low and stable inflation thereafter. The experience of the past suggests that using monetary policy to support the economy in the face of negative productivity shock had a little success. Rapach and Wohar (2005) describe how the inflation impacts on real interest rates by causing structural breaks. The breaks in inflation rates and real interest rates often coincide, with increase (decrease) in the mean inflation rate as we move from one regime to the next typically associated with decreases (increases) in the mean real interest rate.
The main focus of this paper has been explaining inflation, interest rates and finally the impact of inflation in interest rates. When there is inflation, interest rates changes by causing problems to businesses, government and consumers, Mishkin (2007b). Inflation and higher interest rates causes the budget deficit (A. Isenmila and O. Okolie, 2008). When there is a budget deficit, government find ways of financing the deficit through borrowing from commercial and merchant banks or from the non-banking public through the issue of short-term bonds and monetary instruments, A. Isenmila and O. Okolie (2008). Rapach and Wohar (2005) describe how the inflation impacts on real interest rates by causing structural breaks. The breaks in inflation rates and real interest rates often coincide, with increase (decrease) in the mean inflation rate as we move from one regime to the next typically associated with decreases (increases) in the mean real interest rate.