Inflation and Interest Rates

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Concept of Inflation

Price stability is a primary macroeconomic goal of any government in other words for all governments a low and stable rate of inflation is desirable. Inflation is a persistent increase in the average price level in the economy generally measured through a matrix like consumer price index (CPI) or wholesale price index (WPI). The word “persistent” has significance in identifying inflation in the economy. A single increase in prices is not called inflation but a sustained increase in the price level would be called inflation. The reason for governments to prefer a low rate of inflation is because there are major negative consequences associated with high levels of inflation as follows.

Loss of purchasing power

If the rate of inflation is 6% it means that the average price of all goods and services in the economy has risen by 6%. If one’s income remains constant, he will not be able to buy as many goods and services as he could before the increase in the average price level. This is a fall in real income, which means that there is a decrease in the purchasing power of income due to inflation.

Effect on saving

If the interest earned on savings is say 3% annually, and the inflation rate is 8%, then the real rate of interest (the interest rate adjusted for inflation) will be negative, and the savings will not be able to buy as much as they could have earlier. Since money loses its purchasing power one would have been better off spending the money rather than saving it. Consequently inflation discourages savings. If people really intend to save money, rather than spend on consumption, they may choose to invest in fixed assets as housing, precious ornaments etc. This shrinks the quantum of savings available in the economy for investment purposes which adversely affects economic growth.

Effect on interest rates

Commercial banks charge interest on the money people who borrow from them. In periods of high inflation banks raise their nominal interest rates to ensure that the real rate that they earn remains positive.

Effect on international competitiveness

When a country has a higher rate of inflation compared to its trading partners, its exports will become less competitive, and imports from lower-inflation trading partners will become more attractive. This may lead to fall in export revenues and inflate the expenditure on imports and thereby worsening the trade balance. As a consequence unemployment may increase in export industries and also in industries that compete with imports.

Uncertainty

While a fall in the availability of savings will reduce investment, the uncertainty associated with inflation will also discourage investing. This will again impact economic growth adversely.

Labor unrest

With sustained inflation workers may feel that their wages and salaries are not keeping ahead of inflation. On the other hand companies also experience shrinking margins as they would not be able to pass on the entire impact of cost increases to customers and would necessarily target cost reduction in various activities out which a key element may be cost of labor. This may result in disputes and erosion of industrial relations between unions and management.

Types of Interest Rates

There are various types of interest rates with the different ways that they are charged. Below are the different types of interest rates.

Simple interest rates

Simple interest is calculated by multiplying the loan amount by the interest rate by the number of payment periods over the life of the loan. Simple interest is only calculated towards the principal amount that is unpaid. This type of interest is basically the opposite of the compound interest rate, it is not charged on a daily basis and the debt can be paid in a most effective manner.

Compound interest rates

Compound interest relates to charges the borrower must pay not just on the principal amount borrowed, as in simple interest, but also on any interest outstanding at that point in time. Compound interest is charged on a daily basis. The problem with this interest is that its calculations are complex and is extremely hard when trying to find out how to pay off debt because most of the consumer’s minimum payments go towards the interest rates each month and not the principal balance. Most creditors offer this type of interest for obvious reasons.

Fixed interest rates

Fixed interest rate is an interest rate that is basically locked in for the duration of the agreement. Fixed interest rates can be beneficial, but make sure that the agreement is read thoroughly. Some of these agreements may state that after a few months the rates will increase.

Introductory interest rates

This is an interest rate that is given in the beginning of the offer for the time stated on the agreement. It is very important not to get sucked into an agreement because the initial sign up looks great. After the introductory rate the rates go up and you will be shocked to see how much you now owe on top of your balance in interest rate fees.

Variable interest rate

Variable rate interest loans allow the lender to set the interest rate to whatever market conditions demand at any given time during the life of the loan. A variable interest rate varies depending on the changes in cash rate of other changes made by your provider. These interest rates basically flip flop at any given time due to the providers guidelines.

Partially fixed interest rate

This is an interest rate that allows the consumer to pay partial interest on one part of the loan and variable interest on the other. This type of rate is given a guideline from the creditor.

APR

APR, or ‘Annual Percentage Rate’ is the percentage of interest payable on the loan based on a yearly term. In many countries, financial lenders must disclose the APR so that consumers have the chance to measure all lenders against a common metric. For example, many credit card companies declare their interest rates in terms of a monthly interest rate, say 2%. The actual APR in this instance is 24% (12 months X 2% = 24%),  APR gives borrowers the chance to determine what the actual overall cost of the loan will be, but keep in mind that there may be additional ‘set up’ or ‘administration’ fees that are not included in the APR calculation. Particularly for smaller loans over shorter time periods, these extra fees can make a big impact.

Interest Rates

The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets. Interest rates are typically noted on an annual basis, known as the annual percentage rate (APR). The assets borrowed could include, cash, consumer goods, large assets, such as a vehicle or building. Interest is essentially a rental, or leasing charge to the borrower, for the asset’s use. In the case of a large asset, like a vehicle or building, the interest rate is sometimes known as the “lease rate”. When the borrower is a low-risk party, they will usually be charged a low interest rate; if the borrower is considered high risk, the interest rate that they are charged will be higher.

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