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Inflation in Australia has hit a sky high 5.1%, the highest it has been since 2008. The price of fuel, electricity, and even lettuce has all gone up by more than 50% in the past year. To counter the rising inflation, the Reserve Bank of Australia (RBA) has raised the official cash rate in consecutive months, the first time this has happened since May 2010. The cash rate is now at 0.85%, up from 0.1% just over six weeks ago. And more interest rate rises are still to come. It’s all part of the RBA’s plan to keep Australia’s inflation between its target of 2 to 3 percent. But how does this work? How does increasing the cash rate reduce inflation? Increasing Interest Rates Reduce Demand The Reserve Bank of Australia is responsible for setting the cash rate, which is the interest rate that banks use for overnight loans to each other. The cash rate helps determine the interest rate at which money is lent or borrowed by consumers and businesses. So when the RBA increases the cash rate, it raises the cost of borrowing for banks. And naturally, the banks pass on the higher cost of borrowing to consumers and businesses. This means that when the RBA raised its cash rate by 0.5% last week, consumers and businesses will have to pay more to borrow money. *However, it’s important to note that a 0.5% increase in the cash rate doesn’t mean that the interest rate quoted by the banks will also increase by 0.5%. This higher cost of borrowing will reduce the demand of products and services and reduce the overall economic activity. For example, if your weekly mortgage repayments go up, you have less money (discretionary income) to spend on other goods. For businesses, a higher loan repayment might mean that the business will be less likely to invest in new equipment or hire additional workers. This reduced demand for goods and services is exactly what slows down the rate of inflation. Basic economics says that the prices of goods and services increase when there is greater demand (law of demand). But when it costs more to borrow money, the overall demand for goods and services decrease. Whilst prices might not necessarily decline, the rate of inflation usually does. Real Life Example To better understand how the two are linked, let’s consider a typical household with two loans: a home loan and a car loan. Inflation has been sky high during the pandemic, and thus the price of everything has gone up. If the interest rate on your loans goes up, then you would need to spend more of your disposable income on those repayments. As your repayments on the loans increase, the household has less discretionary income to spend in other areas, such as going to the cinema. From the cinema’s perspective, there’s a drop in demand as most movie-goers can no longer afford that luxury. The cinema’s revenue decreases. If you’re a cinema owner, you might decide to reduce the price of the ticket in order to entice some of the movie- goers back. But because you decided to drop the prices, your profit margins decrease. The tighter profit margin means that you can no longer afford to hire all the staff, so you decide to lay some people off. As a result, less people have jobs. Thus less people will have the money to go to the cinemas, further reducing the demand for your goods. Now imagine it’s not just one cinema, or one business, but the entire country’s economy. Even small increases in cash rates can have ripple effects that significantly slows down the country’s economic activity. Thus, companies would no longer be able to raise prices. Thus, by increasing the cash rate, the Reserve Bank of Australia has reduced the ability of companies to raise prices for goods and services, thereby slowing inflation.