Inflation - Part 2 of 3

Inflation reduces the purchasing power.

To control, inflation the RBI (Central Banks) increases interest rates. But how does increasing interest rates help reduce inflation.

Here’s how it works:
One pays interest on loans taken and receives interest on deposits made. To allow lending and borrowing, banks also borrow from / deposit with RBI.

By increasing interest rate, RBI achieves the following:
• Banks need money to lend so they borrow from RBI; if borrowing rate increases, they have to increase lending rates
• Loans become expensive and lesser people take loans
• Deposit rates become attractive so people save more and spend less
• Lesser ‘free money’ in the system
• Cost of items reduces as demand for the item falls (assuming supply is constant)

High inflation in India is not an exception though due to some India specific issues (supply side issues in agriculture) inflation is higher than other emerging countries.

Main reason for the inflation has been high globally is due to the loose monetary measures (keeping interest rates low and QE 1 & QE 2) by countries like US and the EU.

Next part: How’s inflation measured and why is not reducing even after interest rates have been increased by RBI many a times in the last 2 years.