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The Effect of Interest Rates on Inflation & Unemployment

The central bank of the United States, the Federal Reserve, is one of the most important influences on interest rates in the economy. Although the Federal Reserve (the Fed) does not directly control interest rates, the Fed does have indirect influence over interest rates to help control inflation and keep unemployment low.

Monetary Policy

The focus of the Fed is to achieve three main goals: maximum employment, stable long-term interest rates and stable prices. To achieve these goals, the Fed uses open market operations, reserve requirements and the discount rate. All three of these tools either increase or decrease the supply of money in the economy. To illustrate, increasing the money supply puts downward pressure on interest rates across the economy. If the Fed decides to decrease the money supply, the result is upward pressure on interest rates. These adjustments are made accordingly with changes in the economy to keep a favorable balance between inflation and unemployment.

Demand

Increasing or decreasing the money supply moving through the economy influences consumer demand for goods and services. Consumer demand is partly influenced by the income available to buy things. Interest rates influence some of the sources of consumer and business income like the value of investments, loans and foreign exchange rates. For example, if the Fed decides the economy needs to be stimulated, the Fed can push interest rates lower by increasing the money supply. Lower interest rates make borrowing cheaper so consumers can afford to buy more and business can afford to invest more. Higher consumption and higher investment levels generate more demand for goods and services in the economy, which influences inflation and unemployment.

Output

In keeping with the scenario in which there is a high demand for goods and services, the effect is a higher level of economic output. Output is the amount of goods and services produced in an economy at a particular time. As higher demand pushes output higher, business react to the increase in demand by hiring more workers to produce the goods and services demanded by consumers and business. The connection between interest rates and unemployment is that lower interest rates help decrease unemployment.

However, the opposite is true during periods where interest rates are high, which decrease demand and output falls to meet the new lower demand. Less output requires fewer workers, driving unemployment higher.

Prices

Inflation is the upward change in prices across the economy, which is tied to higher interest rates. Inflation occurs when there is an increase in the demand for money to make investments or buy goods and services. As more demand increases output, more business and consumers are competing to obtain funds. This increased competition drives interest rates upward despite efforts by the Fed to keep interest rates reasonably low. The effect of higher interest rates translates into higher borrowing costs for businesses, which increases the price of output and consumers pay more for the same goods.

To counter the effects of inflation, the Fed adjusts the money supply to place downward pressure on interest rates and keep inflation from damaging the economy.



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