Re: The Impacts of Decreasing Interest Rates, Decreasing Inflation, Less Consumer Con
When looking at interest rates and inflation it is often useful to think about them in context to the real interest rate.
If i = nominal interest rate and
r = real interest rate and
p= inflation rate
Then approximately (not exactly, but near enough) you can say that:
r = i - p
In other words, as inflation rises, the real interest rate declines. Think of the following example. If you have $100 and want to find out in real terms how much you would have in a years time if the nominal interest rate was lets say 5% ; you would need to also consider inflation. If inflation was say 3%, then the real interest rate would be 2% (approximately). I wont show you the mathematics, but you can probably see the intuition.
Because firms consider real interest rates when making investment decisions; we can now derive a relationship between inflation and output. As stated in the previous post interest rates are important in that firms will borrow more when interest rates are low. This stimulates investment. Subsequently when inflation falls, investment will also fall ceteris paribas. But if you remember how central banks conduct monetary policy, you will notice that inflation and interest rates tend to move in the same direction, so if the inflation rate falls, the interest rate will also fall (note this is based on a rule for optimal policy such as the taylor rule rather than a notion of causality which would suggest that as interest rates rise inflation falls). Subsequently the effect of inflation may be ambiguous.
Consumer spending is always a function of consumer confidence. If consumers feel that times are good, they are more likely to spend more. for example would you buy a plasma screen tv in the current economic climate? would you have been more likely to 3 years ago?
