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Interest Rates and Inflation

In theory, lower interest rates lead to higher prices by boosting economic activity and weakening the value of a country’s currency. It boosts economic activity by making it cheaper for businesses and people to borrow money, thereby making it cheaper for a business to build a new factory – and then buy equipment and hire workers for that factory, for example. It also makes it cheaper for people to borrow money to buy a new home, which means that they’re more likely to go out and buy a new sofa and TV to fit out the home (also, existing homeowners might sell their home at a higher price and spend some of the money). The economic boost from higher demand leads, eventually, to companies being able to raise their prices for their goods and services – and thus inflation rises. When a country’s interest rate goes down, international investors are less willing to invest in that country (because they’re not getting paid as much in interest). And so, the value of that country’s currency goes down. In turn, it becomes more expensive for that country to buy goods from abroad. For example, if the US dollar goes down in value, olive oil that is made in Italy goes up in price for people in the US. And so, as prices go up, inflation does too.

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