MGT 411 gdb solution 2016

·       There are 2 theories to explain the relation between inflation and economy.

o   Demand-pull theory:

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§  Lesser Interest rates will attract lesser savings. So, people tend to spend more when the interest rates are less. Thus creating more demand for goods and services.

§  Lesser Interest rates will encourage people to borrow more money/ So, again people tend to spend more borrowed money when the interest rates are less. Thus creating more demand for goods and services.

§  When supply of goods and services is less than the demand, prices go up. This also results in inflation.

o   Cost-push theory:

o    

§  When the cost of the raw materials and inputs increases, the cost of end products also increases. This rise in cost of goods and services pushes the price higher resulting in higher price.

In a healthy economy, Inflation and Interest rates move hand in hand as shown in graph below and are mutually dependent on each other.

·       Like we discussed in demand-pull theory, Lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation.

·       If the central bank decides that the economy is growing too fast (which is a bad sign in the long term) using indexes like consumer price index (CPI), wholesale price index (WPI), They will try to minimize the effect of it by increasing the interest rates and vice versa.

·       This rising interest rates in turn will encourage people to save more and borrow less thus reducing the amount of money in circulation in the market. Lesser money in the market makes it difficult to buy the goods and services thus slowing down the rise in price.

·       In short, A stable economy is a healthy economy with right wages and less unemployment.

 Relationship:
 In general, as interest rates are lowered, more people are able  to borrow more money. The result is that consumers have more money to  spend, causing the economy to grow and inflation to increase. The  opposite holds true for rising interest rates. As interest rates are increased, consumers tend to have less money to spend. With less spending, the economy slows and inflation decreases.