Could Raising Interest Rates Reduce Inflation?

What is Inflation? Inflation is when prices in goods and services rise and can weaken the value of currency. It can have many differing factors as to why it happens, and can be defined by three types: demand-pull, cost-push, and built-in inflation.



Demand-pull is when supply is under produced but demand is high, so it “pulls” inflation higher. There can be several causes of a demand-pull inflation such as, growing economy, increasing export demand, government spending, inflation expectations, and more money in the system. It can often be compared to cost-push inflation which it is in contrast with.


Cost-push is the rise in production costs to make a good and can push costs higher to cause inflation. Causes for cost-push inflation are often unexpected natural disasters or shortages making materials harder to obtain. Increased labor costs can also be a cause for inflation as employees would be more expensive and harder to obtain. This also falls into built-in inflation.

Built-in inflation

Built-in Inflation occurs when wages or salaries are expected to rise with increased goods and services. As the first two types of inflation occur the third one may start to follow, as goods and services become higher cost employees may demand higher compensation to keep up with living costs. If employers don’t keep wages competitive, they may end up with a labor shortage.


Many other factors can cause these types of inflation such as supply chain shortages, geopolitical events, involvement in war, spikes in energy prices and so forth.


The Federal Reserve System functions to maintain a low inflation rate by raising interest rates which raises the cost of borrowing money. With interest rate hikes, the annual percentage rate, or APR, may end up rising. Interest rates tend to follow inflation due to being a primary tool by central banks in order to manage inflation.


When inflation climbs high the Federal Reserve will put in place high interest rates to encourage people to spend less thus creating a lower demand for goods. Higher interest rates create more expensive loans for both businesses and consumers. This also makes it hard for companies to try and raise capital as it may cause a fall in profits as rates increase. Interest rates rising can also lower stock prices in the market and if enough companies experience declines, the whole market can go down.