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Relation between Inflation and Interest Rates (graph)

A number of people and students wonder about the relationship between inflation rate movements and the quarterly interest rate (nominal and real interest rate). Here are observations based on Canadian data over a 50 years period that tracks T-Bill interest rate, consumer price index, and real interest rate.

This graph illustrates a number of movements. Firstly, inflation rate and the real interest rate appear to move in opposite directions at all time. Secondly, generally in the long-run the nominal interest rate appears to lag behind the movements of the inflation rate, however, moves direction, whether up or down. What causes these phenomenons to occur?

Generally the movements of all three curves is relatively small in the years prior to the 1970’s. However, upon the monetary policy shift from a classical perspective to a more short run Keynesian ideology, substantial movements between the lines are observed. Increased government spending during the 1970’s created an immediate increase in the money supply.

The quantity theory of money suggests that once the governments began spending, thus increasing the money stock, the inflation rate would rise as well. In order to counteract this movement, monetary policy began to respond to the inflationary trends. An attempt to curb spending and decrease the money supply was made by raising nominal interest rates. The fiscal decisions, and subsequent monetary responses caused interests rates and inflation to fluctuate and rise dramatically. The real interest rate is a mere measure of the movements between these two variables.

The reason why the real interest rate moves in the opposite direction of both nominal interest rate and inflation is due to how we derive the real interest value and what it represents. We understand the relationship to be ~ real interest rate = nominal interest rate – inflation rate. This relationship suggests real interest rate measures the return-the nominal interest value-s-minus the purchasing power lost through inflation, of a particular investment. Therefore the inverse movements of the two variables is described by the position of these particular variable. If the price level has risen more than your nominal holdings of cash, then your real value of this particular holding will be decrease, or move in a negative direction. The same concept applies tel interest rates, however, the nominal value of interest rates is in fact policy controlled, and can be manipulated to increase the real interest rate, or decrease inflation.

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