We usually hear these two macroeconomic terms put together. Inflation refers to the rate at which prices of commodities and services rise and value of money decreases. So, 5% inflation rate means there is 5% increase in general price level over a year.On the other hand, interest rates are cost of borrowing the money or price of money. Interest rates are decided by central bank of any country. Like in United States, it is decided by Federal Reserve.
If interest rates are decreased, people can borrow money easily because it becomes cheaper for them. Consumers will have more money to spend, which leads to economic growth and finally inflation increases.If interest rates are increased, money will become costlier and consumer will have less money to spend, this will led economy to be slow and inflation will decrease.
Central bank of any country uses interest rates to decide growth of economy. Higher interest rates encourage savings. This is because homeowners perceive an increase in cost of borrowing, so they want to keep money in banks and earn higher interest on their savings.
For example, if Central bank increases the interest rates, more homeowner will find it difficult to buy a car or other consumables since borrowing becomes costlier. It leads to slowdown in economy and thus price of money increases and inflation decreases.
Talking on a preventive note, if the target is to curb inflationary pressure, reserve bank increases the interest rates. But if at any time inflation falls below the target level, it is likely that economic growth rate too falls and recession may be feared.
Recession impacts the employment and consumption negatively. Unemployment creates a situation where people sit at their home with little disposable income in hand, which in turn lowers demand thereby increasing unemployment further.
This recessionary trend curbs through the cheap money. This is done through cutting interest rates. Lower interest will make homeowner feel that the money is cheaper now and that they have more disposable income in their hands.
One of the better methods to check inflation and ensure economic growth is to increase investment. When investment increases, it in turn leads to employment of more people to workforce. More employment means having more disposable income and eventually the economy grows.
In some cases, Central bank does not increase the interest rate even if the inflation is high. This is because they feel that this inflation is cost-push inflation like food price rise. So they feel that keeping an eye on inflation is better than curbing it and being trapped again in recession, which is considered to be more harmful to the economy.
Last but not the least, through managing the interest rates, Central bank tries to achieve maximum employment, more stable prices and desired level of growth. Hyperinflation can be experienced if economy is growing too fast.
On the other hand, if inflation is curbed beyond a level, it will cause stagnation. Central bank tries to strike a right balance between these two extreme conditions. Inflation lies somewhere in the middle.
The right level of inflation at right level of interest rate will help economy to achieve maximum employment and desired investment.