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Question by : How does a decrease in interest rates cause an increase in inflation?
“Lowering interest rates stimulates growth to avoid recession; however, that will eventually cause inflation. Raising interest rates will slow inflationary growth, but may lead to a recession.”

In simple terms, how does this work?

Best answer:

Answer by Sienna
Inflation is defined both as an increase in the supply of money or money substitutes; and as a general rising of prices.

Say on the unhampered market it costs to borrow 0 for a year. So you borrow 0 and one year later you have to pay back 0.

Now the government’s central bank manipulates the price of credit so that it costs to borrow 0 for a year. In other words, it’s cheaper. For the that it would have cost on the unhampered market, you can now borrow 0; or for only , borrow 0 for a year.

Either way, that is an increase in inflation by the first definition, namely an increase in the supply of money substitutes- credit – compared to the situation the unhampered market.

The person receiving the money or money substitute at the new rate is now at an unfair advantage in the market. People who borrowed at the old rate have to pay for every 0 of goods they buy. People who receive at the new rate, other things being equal, can outcompete the others by bidding up the price for scarce resources. (That is why the bubble first appears in the sector of the economy where the counterfeit money was injected, as happened with the housing bubble; the rising prices then spread to the rest of the economy.)

That is why a decrease in interest rates causes an increase in inflation by the second definition, namely, a general rising of prices.

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