Banking Basics
Ever wonder how you can barely buy a car with what your grandparents bought a house? Here's the answer: inflation. Inflation describes an increase in prices over time. That said, don't think of inflation in terms of higher prices for just one good or service. Inflation refers to a price increase across sectors and industries.
When it happens, the purchasing power of your money decreases. This means that the number of goods and services you can buy with a unit of currency, such as a dinar, will be less than what you could have purchased before. For example, a carton of milk in 2015 cost you around 1.50 JOD, but now it costs about 2.50 JOD.
Unfortunately, this is just one effect of inflation. In this article, we're going to go into another: rising interest rates. But first, we're going to go into some of the causes of inflation:
Cost-push inflation
This happens when the supply of goods or services is disrupted, but the demand for them is still the same - pushing up prices. Usually, natural disasters and wars are what stop manufacturers from producing enough of certain goods and keeping up with consumer demand. Thus, allowing them to raise prices, resulting in inflation.
Crude oil, the natural resource used to produce gasoline and diesel fuel, is one commodity that experienced shortages in supply recently. When Covid-19 first hit worldwide, fewer people drove, so oil-producing companies cut back on their production. But as restrictions loosened with time, demand for car fuel rose again, and so did prices.
Events like the pandemic and the Russia-Ukraine war caused oil price increases and cost-push inflation because they led to the shutdown of some refineries. Demand usually remains the same, but the refineries available to produce gas have to raise prices because they don’t have enough crude oil to turn into fuel.
Demand-pull inflation
This happens when the demand for goods or services increases, but their supply remains the same - pulling up prices. Don't get us wrong, a little more spending never hurt anybody! In fact, governments consider steady growth in consumer demand a sign of a healthy economy. But if consumer demand exceeds the production capacity of manufacturers, prices will rise, causing inflation.
Increased money supply
Suppose the Central Bank of Jordan were to increase the amount of money in circulation by printing more. You and other consumers will have more money to spend. But manufacturers of goods like food, clothing, and cars won't respond to your eagerness to buy these goods by producing more. Instead, they will raise prices, making you unable to buy the same number of goods with the same amount of money.
So, what's the relationship between inflation and interest rates?
You can probably tell by now inflation happens when there's an imbalance between supply and demand. Central banks raise interest rates to reduce the demand - and thus rising prices - for certain goods.
How does this tame inflation? Let's break it down. An interest rate is an amount you are charged for borrowing money. When interest rates rise, you and other consumers will be pushed to slow down your spending and decide that now isn't the right time to get a loan on a car or a house. This reduces demand, in turn, slowly lowers inflation.
Yes, raising interest rates makes borrowing money more expensive. But it's necessary because inflation staying high for too long is a problem. Raising interest rates allows an economy to slow down just enough to bring down prices to make the ride ahead less bumpy.
