Inflation can be defined as the rise in the prices of essential commodities and services. This is measured on an annual basis just like the interest rate. Although there are negative connotations associated with rising prices, inflation is not always a bad thing.
In fact, it often points to a robust economy and greater spending power. There is a deep rooted link between interest and inflation. This is described through the economic theory of demand and supply.
A lower interest rate means people have more money through borrowings and hence can spend more on purchases. This raises the demand for goods and in an environment where the supply is held steady, prices and thus inflation is bound to go up.
Not just the fluctuation in interest but also the cost push theory offers an explanation for rising prices. Often, the cost of production increases which will undoubtedly increase pressure on the manufacturers who want to retain their profit margins. This again would lead to a surge in the price of services and goods.
Another reason for the growth in inflation is that a higher interest rate translates to greater purchasing power in the hands of consumers which results in a strengthening of the economy and thus causes an increase in inflation.
So, how does the government control inflation through interest rate modifications?
The government closely monitors measures of inflation like the Consumer Price and Product Price Indices. Although ensuring that the economy grows at a specified rate is important for the economic controllers of any nation, allowing the growth to exceed beyond a certain point can lead to burnout and dangerously high inflation.
To counter such a development, the government keeps a tight control on the interest rate offered to end borrowers and banks. This helps to contain the flow of money into the markets and thus the spending ability of consumers.