When inflation is running wild, what should governments do to the interest rates?

My answer on Quora:

It depends on the source of inflation. Interest rates impact borrowing/savings decisions and can also send a signal about the seriousness of the central bank (whose mandate typically includes some kind of price stability).

  • If inflation shoots up because of a supply shock, then there may not be much interest rates can do. A supply shock in this context is when the price of raw materials or any other input in the production process shoots up. This could be due to a supply shortage or a sudden spike in demand from another part of the world or economy.
  • If inflation shoots up because of an exchange rate devaluation in a country that imports a lot of what it needs, then there may not be much interest rates can do. When the exchange rate depreciates rapidly, then imports become much more expensive. This is similar to the effect of a supply shock. It becomes very expensive to import what you need, and prices rise as a result. Prices for a broad range of goods can be affected too, raising the general price level.
  • If inflation shoots up because of rapid credit growth, then raising interest rates could help stabilize or lower inflation. Higher interest rates encourage more saving and less borrowing. So, if too much borrowing is driving up prices, then raising interest rates could be a good idea, all else equal.

 

  • If inflation shoots up due to a sudden shift in expectations, then raising interest rates might help. Here, the source of inflation is coming from the perception that prices will rise fast. So, people go out and buy a bunch now before prices get even higher. On the other hand, price setters are also facing higher prices from their supplier, and also will be less willing to sell at the current price, expecting that they can sell at a higher price tomorrow. The extreme result is hyperinflation. In this example, a strong anchor by the central bank is needed to control expectations. Raising interest rates dramatically might set that signal that people need to see to believe that things are in control. The interest rate hike would need to be large enough to make up for the high rate or inflation. It would need to be higher than the inflation rate so that people can believe they will get more out of putting their money in the bank than spending it. If that rate is too high to be feasible, then a broader strategy is needed.
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