We often hear in the news that central banks will raise interest rates in order to slow down inflation. However, may of us are confused as to how the whole process works and how our wealth is affected by inflation. We do understand that it costs us more to borrow money when interest rates are high and our adjustable rate debt can spiral out of control. The cost of borrowing money is the least of our worries.
The European Central Bank recently announced that they will be raising rates to the highest level since 2001 in order to stem the fast paced economic growth. The goal is to raise rates to a level that no longer stimulates economic growth. Companies might start increasing the price of goods and labor unions have pushed through wage increases causing inflation.
When inflation occurs money loses is purchasing power. That is each dollar purchases less goods than it did prior. Therefore if you paid $3 dollars for a can of Lysol today it might cost you $3.20 by the end of the year. Without wage increases the purchasing power of worker declines.
The consumer price index shows the price of products throughout the U.S at any particular time. If we analyze the consumer price index from 1950 to 2003 we will find in 1950 the index was around 25 and in 2003 it was around 190. Thus products have moved upwards at spiraling rates.
Since 1970’s the average purchasing power of a middle class family was around $40,000 in today’s value. In 2006 that value was somewhere around $35,000 per annum. Thus inflation has eaten up people’s income cause a decline in the American standard of living. The trend doesn’t appear to be slowing so Americans should find themselves poorer in the future.
When the government wants to influence inflation rates they may raise or lower the interest rates. Let us say that inflation is moving upward and the government wants to keep it under control they may raise the interest rates so that it becomes more expensive to borrow money. Since capital for investment, building house, etc. is more expensive it is borrowed less and growth is slowed. When growth is slowed the inflation rate slows as well.
The government continually monitors the state of the economy and the cost of borrowing money because it must ensure the adequate living of its citizens. If inflation spirals out of control people lose their wealth and this causes social upheaval. Upheaval can lead to all types of major changes, riots and even the removal of government officials.