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%



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