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I heard not long ago that because of inflation rising up in China, the China Bank will rise its interest rate of 0.25%.
I am quite new to the financial world and do not really understand how this is linked.

My understanding:

The rise of interest rates will make money more expensive inducing less loan to be contracted by individuals. Because of that, price won't continue to rise.

My understanding is very basic, can someone help ?

  • You have the right idea. Raising interest rates makes it more expensive to borrow money which will reduce the amount of money in circulation. Simply put, there is less money to chase the goods being produced which brings down prices. – Muro Apr 23 '11 at 10:29
  • @Muro. When we talked about inflation, we make reference to the amount of money in circulation, the rise of prices is just a consequence, is that right ? – Luc Apr 23 '11 at 11:11
  • yes...rising prices are a result - or consequence - of having more money in circulation. – Muro Apr 23 '11 at 11:49
  • And "more money" can be a consequence of fewer goods, not just creating new money. Economies can shrink as manufacturers cut back on production, retailers cut down on inventory, and everyone reduces staff. The same amount of money is still in circulation but there is now less productivity and goods available. – Turukawa Apr 23 '11 at 14:50
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This is similar to the overnight lending rate set by the US Federal Reserve Board.

If money is more expensive to borrow (higher interest rate) then less will be borrowed. Commercial and consumer loan rates follow up or down via market pressures (though possibly to a lesser extent in China) to adjust to the new central bank rate.

Money creation is driven in part by fractional reserve banking: banks are required to have but a small percentage of deposits on hand in cash, and the rest can be lent out, deposited in another bank that has the same fractional reserve requirement, and that money can be lent out, etc. Higher interest rates dampen this lending activity, so inflation is toned down.

  • Only the last paragraph answers the question well. Since there is a trickle up effect that reduces money supply overall I think the answer should be reworded to account for this order properly. – Frazell Thomas Apr 24 '11 at 6:14

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