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Does low inflation always mean low interest rates? | Economics Blog

Does low inflation always mean low interest rates?


Readers Question: Does low inflation always mean low interest rates?

Yes, Generally low inflation will lead to low interest rates.

The UK has an inflation target of CPI = 2%. Therefore, interest rates are used to achieve this target. If inflation falls to below 2% the MPC will cut rates to maintain economic growth. There is no need for high interest rates when inflationary pressures are low.

For example: If you had an inflation rate of 1% and interest rates of 7%. There is a very high real interest rates (7-1 = 6%) Therefore, this would encourage saving and discourage borrowing and spending. This is likely to cause a recession so Central Banks would avoid it.

Will the Monetary Authorities ever Increase Interest Rates when Inflation is Low?

They might increase interest rates a little if:

  • They forecast inflationary pressures will increase in the future
  • They want to increase the value of the exchange rate
  • They want to encourage saving as opposed to inflation.

However, as a general rule, Central Banks would rarely have interest rates more than 3 % points above the inflation rates. e.g. if inflation is 2%, it is unlikely that interest rates will be much more than 5%

 

4 comments ↓

#1 zafar on 12.20.08 at 9:46 am

IS LOW INFLATION AND DEFLATION THE SAME???

#2 shweta on 03.05.09 at 12:01 pm

Deflation is when inflation rate becomes negative or is below 0.

Low inflation or disinflation is the rate of inflation growing at a slower pace

#3 ashish on 06.19.09 at 10:40 am

If inflation is negative i.e. deflatiion then why the rates of every thing is increasing??

#4 Donnie on 09.25.09 at 6:18 pm

if its so bad lets boycot every thing then. but thats just me im all about anarky.

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