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How does Interest leads to Inflation

By Edited Oct 18, 2016 1 0

Main Cause of Inflation

An Insight

Being a business graduate we are often told that inflation is due to the increase in demand (or decrease in supply), as a result of which the government prints more currency, thus leading to currency devaluation, increase in prices and ultimately introducing us to the concept of inflation.

Thinking about this we might be more interested in the factors that increase demand. Well these can be seasonal like increase in demand for grocery and apparels during christmas, increase in demand for dates during ramazan or shortage of supply during wars. However inflation is not a result of increase in a few commodities such as those mentioned here. And we are not talking about seasonal inflation here. We are talking about inflation that gives us the reason to ask for interest on our investments as a result of devaluation of money with time.

Now coming to the concept of devaluation of money with time, we usually have a question that how does time affects value of currency? Stating that, time has nothing to do itself with currency value, its the changes over a time period which affect the currency value. So what are these changes and where do they come from. Apart from seasonal changes its the change in an individual's state of mind for the lust of money. Over a time span individuals, corporations and businesses all are busy in accumulating wealth (there is less circulation of money as compared to its accumulation). Thereby they look for ways in increasing their profits which make them demand higher interest rates on their investments or any loans that they are giving for business or personal purposes.

Lets go into this more deeply.

An increase in interest rate (or the mere presence of interest) means that the borrower will pay the lender an amount that is in excess of the amount borrowed. Now a borrower is definitely going to increase the prices of its products or services in order to get profit out of their loan while they end their liability. The excess amount charged may not seem much at an individual level but looking on a collective level it makes a huge difference. The business transactions done on credit (credit purchases) result in increasing the cost of goods or services sold by that business, thus ultimately increasing the price of  goods or services that come in the market and giving rise to inflation.

By now we know how interest leads to inflation. However there are products that get cheaper with time, such as computers and gadgets. Here we should also consider other factors that increase the price of a product, such as advancements in technology in this case.

The given phenomenon of interest leading to inflation has been proposed after deep pondering and research which is the only reason that seems logical for the cause of rise in prices and the adverse effects that interest based system has on markets worldwide.




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