“Interest rates are the main tool that central banks use to curtail inflationary pressures. The main focus is to dampen demand by consumers who will find the costs of borrowing going up and their ability to carry debt diminished. They will find that borrowing to buy durable goods will become more expensive, such as cars or other items that require going to the bank for a loan. With demand decreasing it is expected that supply shortages that led to inflationary pressures to decrease. Other tools that were used to fight inflation in the past were tax increases as ways to dampen consumer spending by reducing disposable income. Yet, tax increases are politically unpopular and as a result, the government has given control to the monetary authorities to fight inflation via the interest rate route, since the independence of the Central Bank makes it less susceptible to political repercussion for its actions.
Interest rate increases have also overall negative effects on stock prices as these prices incorporate the expectations of a decline in future profits due to the fall in overall demand. So consumers who also hold their savings in stocks will see their wealth decline as well and they will be inclined to be more prudent with their spending. One might argue that interest rates will be beneficial to those with savings accounts, yet the vast majority of savings is in terms of stocks and as such the wealth effect of a rise in interest rates will be also overall negative.”
Dr. Thanasis Stengos,
Professor of Economics, Department of Economics and Finance