Question

Explain to someone who knows the definition of inflation and not much else in economics why if expected inflation and/or inflation risk goes up, interest rates will also likely go up. More admiration for you if you use the present value, future value terminology and jointly present the case for interest rates and bond prices.

Answer 1

As we know inflation is the general rise in price level in an economy at a given period of time. There are various approach to understand this term -

• Monetarist approach

This approach makes use of Quantity theory of money. As per this theory, inlation is purely a monetary phenomenon and price level is direcly proportianal to amount of money in circulation.If money supply is rising much faster than production of goods and services then this results in prices increasing across sectors. In other words, too much money chasing too few goods and services. The reason behind production not matching the pace at which incomes and money supply are growing could be due to structural constraints, rise in consumption, Central bank printing too many notes, credit not available as per requirement ( further investment in production cannot take place because past credit is locked in industries which have gone bust and bankrupt. So rising old bad debts limit new investments)

• Neoclassical approach

As per this approach the interaction or mismatch between forces of Aggregate demand and aggregate supply causes an economy to in disequilibrium state. When Aggregate demand curve is rising as compared to aggregate supply curve it leads to inflationary conditions or demand pull inflation. Similarly, when prices of inputs are rising this results in increase in final price of output. So given demand, Aggregate supply curve shifts leftwards. This is called cost push inflation.

• Keynesian or New keynesian approach

As per this approach if consumption is growing at faster rate than total output or if the economy is not able to adjust to new equilibrium due to infusion of Govt. expenditure leading to inflationary condtions. This situation arises when there is an inflationary gap (Actual GDP is higher than the potential full employment GDP.) Here in short run as money supply is fixed and exogenously determined by Central bank So interest rates rises as a result. Higher interest rate induces consumers to save greater proportion of their income and consumption is contained.

Further nominal interest rate rise due to inflation as it related with inflation as -

Nominal interest rate (r) = Real interest rate(i) + inflation (p)

Let us suppose that it is expected that prices will increase next year. I spend x dollars to buy a basket of goods. However next year I have to spend more dollars ( say x + p dollars) on the same basket due to increase in prices. So the x dollars today = x +p dollars next year. (It buys the same basket)

It means Present value of money is greater than the same money next year. So money next year is discounted due to inflation at a higher rate to arrive at Present value of money.

Higher discount rate is nothing but higher nominal interest rates.

Regarding bonds the price of bonds will fall as returns fall due to inflation risk.Present value of bond's yields today > bond's yields next year. ( as inflation erodes the purchasing power of future cash flows)