Comment on the importance of inflation for interpreting interest rates.

Expert Solution

As we know that there is an inverse relationship between inflation and interest rate, as there is increase in interest rate then the loans becomes costlier and hence people takes less loans and therefore they spend less which means demand comes down and hence prices i.e. inflation decreases and vice-versa.

Since there is the negative correlation between the two variables as explained above so the rate of inflation becomes an important factor for interpreting interest rates. If there is high rate of inflation in the economy it means that the interest rates are low and if the inflation rate is low in the economy then it means that the interest rates is high.

If the government want to control one of the two variables then it needs to make the opposite change in other variable. For example if there is high level of inflation prevailing in the economy and the government want to control it, then government can increase the interest rates so the demand and hence inflation will come down.

Rahul Sunny answered 7 months ago

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