Question

Why would nominal interest rates almost always rise when inflation is high? Explain the rationale behind this correlation?

Answer 1

"Inflation is the rise in overall basket of goods and services offered in the economy" . This is solely because of the demand and supply of money in the economy . Just like the price of a particular product varies with its supply in the market .

The rise in the flow of money In the economy causes the inflation to occur.

· Whenever there is an inflation in the economy , central bank of the country intervenes in order to bring the inflation under stabilization.

· The central bank , rises the nominal interest rate as well as the cost of borrowings.

· As such with the rise in this interest rates , the borrowings become costlier and the money supply in the economy reduces .

· With the slowing down of the money supply in the economy , the inflation stabilizes .

Hence it is the Contractionary Monetary policy   which Increases the Nominal interest rates with the rise in the inflation . So nominal interest rates almost always rise when the inflation is high in the economy .

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