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How does the increase in the interest rate contribute to inflation?

LOUISVILLE, Ky. (WAVE) – The Federal Reserve has instituted its biggest interest rate hike in nearly 30 years. Interest rates rose by 0.75% to slow inflation and get the economy back on track.

But how exactly does increasing the price we pay for things help fight inflation?

Andrew Butters, an assistant professor at the Kelley School of Business, explains that it’s all about balancing supply and demand.

Before we can explain how higher interest rates will help curb inflation, we need to understand where inflation comes from. In other words, demand exceeds supply.

“So if the demand is somehow greater than the supply, then what tends to happen is that the price pressure tends to increase. So we’ve seen that now obviously over the Last 18 months and what the Fed is trying to do here is kind of suppress demand a bit,” Andrew Butters said.

The idea is that if someone spends more on their mortgage or credit card payment, they won’t have as much money to spend on goods and luxuries.

In theory, this reduces demand, increases supply and lowers prices.

“By this very construct, what they’re asking is essentially that the economy slow down or fundamentally alter the growth of spending and investment and other kinds of economic activity,” Butters said.

It doesn’t just affect consumers. Businesses are also impacted.

“Companies themselves may have to manage, in particular, maybe they may have to not be so aggressive when it comes to making investments or growing their business because of the cost of borrowing for them too,” said Andrew Butters.

The risk with this kind of move is that if the economy slows too much, it could potentially push it into a recession.

“They’re doing everything they can to try to ease this upward pressure of inflation that’s causing us all to suffer a deterioration in our disposable incomes.”

Federal Reserve Chairman Jerome Powell said more rate hikes were possible. The reserve is expected to raise interest rates by at least 0.5% next month.

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