Interest leads to Inflation- An Article
Abstract: This article carries out a comparative study of the interaction between the interest rate and the inflation rate, which are important indicators of macroeconomic stability for today, and their impact on each other in the examples of the countries of the USA, Uzbekistan and Kazakhstan.
Keywords: refinancing, interest rate, inflation, credit, money, price of money, the central bank, commercial banks, loans.
Today, interest rate and inflation are much more important economic concepts in the traditional economy. Their appearance is also traced in the early stages of development of the global economy. To date, it seems that the theory of Economics and international economic relations can not be represented without these two elements. But how do interest and inflation come from in reality? Is there any relationship between them? Why are these indicators different in different states?
First of all, let’s look at the economic meaning of the interest rate. It is known that in an economy, each produced commodity has its own value, that is its price in other words. This price is formed by raw materials spent and the costs of Labor and capital involved in the processing and finally the added profit. Of course, the prices of these costs also did not come by itself, they also generated value on the basis of supply and demand in the market. This means that the price of the commodity is based on all the expenditures in its whole production path and added profit value. Proceeding from this, the question arises whether money can also be viewed as a commodity or not. Is it possible to set a price for it, after all, it is also a produced commodity?!
Money is a means of exchange, which will be necessary in carrying out the purchase and sale of goods. That is, money should not be considered as a product when participating in the trade of goods. Because in this case, trade remains the same as barter itself in the previous social period, that is, the exchange of goods for goods. At the same time, all the features of the commodity would be converted into money also, which may result in the need for a different instrument instead of money. Some economists believe that money is also a commodity and its price is an interest rate. If money is a normal commodity, and its price is an interest rate, then it does not make sense to return money after paying its interest rate during the purchase process. That is, one of the features of the commodity is that after payment of the price, the right of ownership of the commodity must completely pass to the person who buys it. How do those who claim that money is also a commodity explain how it will be returned after it is issued on credit? If the price of money = the same money + its interest rate, then it is known that the price of any commodity can not exceed its value, that is, for example, the cost of one car is one car, neither one car with a bicycle nor one car with a motorcycle…
Currently, almost in all countries, national central banks, which are responsible for maintaining monetary policy, introduce a refinancing rate continuously. In their opinion, the refinancing rate is the only factor that regulates the flow of capital. But in fact it is not like that because if we look at the economy of the societies that have introduced free-percent finance, which is not based on percent (the countries in which Islamic banks operate or developed nations, which are increasingly expanding the activities of Islamic windows), we can see the capital flow is entering more and more year after year instead of going out. This can also be observed in the dynamics of the increase in Islamic assets. Therefore, the flow of capital does not depend on the interest rate, but on the return of invested capital, that is, how much it will bring into effect. And the interest causes the current money supply to go up without any increase in the demand for money. It just looks like you have to pay a predetermined amount for an unknown job that hasn’t been done. If the value of that work is worth the amount paid, then there is no harm in this, but if the work is not done or is not equal in terms of value, then this situation (prepayment) is nothing more than stupidity.
Now let’s look at the direct inflationary effects of the interest rate. To do this, we compare the interest rate and inflation rate in several countries (USA, Uzbekistan and Kazakhstan). For example, if the interest rate for the United States in January 2018 was 1,5%, then for the same period the inflation rate is equal to 1,8%. If we compare the long-term values of two macroeconomic indicators, through the chart below we can see that the change in inflation is always directly related to the change in the refinancing rate of the Federal Reserve. (Figure 1)
Source: BLS, FRED
According to this graph, in the long-term period interest rate fluctuations lead to significant fluctuations in inflation as well as, in other words when interest rate rises, consistently the inflation rate also increases or conversely. The connection here is not very visible due to the presence of the influence of the global financial market. If you look at another country with a closed economy or an underdeveloped financial system, it becomes obvious that the indicators are almost the same and they are quite affective to each other. We would have cited the main cause of all these as follows:
If the economy introduces lending of money through interest, the amount of money in the loan will be artificially unreasonably increased by as much as the interest in the short run and as long as this increased amount is not compensated by the real production cost in the long run, it directly leads to inflation. Or vice versa, the negative indicator of the interest rate is the main cause of deflation (for example, Japan).
According to some economists, the refinancing rate set by the central banks is seen as a factor in managing inflation. That is, setting a higher interest rate will lead to a decrease in inflation by reducing demand for money. But in fact, inflation arises from the unreasonable increase in the mass of money on credit due to the interest, that is, arises from the interest rate. The thing that economists are not taking into consideration here is that a high interest rate reduces the demand of debtors for money while increasing the demand of creditors for money i.e. they have now the opportunity to make even more profit through the money. As a result, demand for money almost does not change. In addition, the elasticity of demand for money in the interest rate change is very low. Because money is always a means of exchange that everyone needs. Thus, changing the refinancing rate to control inflation in the traditional economy gives the opposite result. Proof of this can also be seen through the graph in Figure 1: the interest rate and inflation rate are proportionally related with each other.
Now we will see the gap between interest rate and inflation. It is known that the issuance of money on credit at an unreasonably fixed interest rate is necessarily spent on the development of a network of production or on consumer spending. If the same money spent project goes to profit in the course of production, then a certain part of the previously unreasonable increase in the mass of money will compensate for the increase in demand for money, which arises as a result of an increase in the volume of production and income. The rest will be replenished on the account of inflation. It follows that the interest rate, which is actively used in the traditional economy, is equal to the sum of the real growth rate in production and the level of inflation, of course, this is is in a country where the financial market is low-developed. Because in large economic countries like the United States, the external demand for the dollar currency can be almost equal to or higher than the domestic demand. Even so, for comparison, we consider the growth rate of US GDP for the years 1990-2018. (Figure 2)
If we compare it with the previous graph, we can witness that the gap between interest rate and inflation also has high rates around 1999, 2005 and 2015, when the GDP had high rates of growth.
Now we consider the state of these important indicators in the economy of Uzbekistan. It is known that in the 90-ies of the last century, as a result of the disintegration of the former USSR, more than 10 countries gained their independence. New independent states with a previously common holistic economy in one state were subjected to drastic changes in their national economies. It was necessary for a certain period of time to stabilize the national economy. At the same time, the situation in Uzbekistan was no exception. That is, there was a gap in almost all spheres of the economy, an economic policy was adopted by the state to eliminate it. Taking into account this, the following table provides data from 2001-th year to the present. According to it, the change in the refinancing rate set by the Central Bank over the past 18 years has directly affected inflation. And it is evident from the following graph that this affect is correct proporsional. (Figure 3)
Figure 3. The comparative chart of refinancing rates and inflation rates in Uzbekistan in 2001-2018
Source: drawn by the author
It is interesting that despite the fact that these two blinds are correct proporsionally connected to each other, in rare cases they form an equal value. Or the sum of the inflation rate and the increase in real assets may not be equal to the current interest rate at all. The reason for this is that the process of adding interest rates occurs several times before the initial interest rate has not yet been added to the production process, that is, the first interest can not immediately earn its value but it faces to get “interested” again and again through the banks by passing from the central bank to a commercial bank and so on, and as a result of this, both the inflation rate and the level of compensation value for the interest continue to change. That is, the central bank provides loans to commercial banks at the refinancing rate, commercial banks also provide those loans to the population at the rates that are higher than the refinancing rate. Therefore, the size of the artificially increased amount of money does not always coincide with the size of inflation in practice, even if the growth rate of production is added.
Such a situation can be learned from the following graph in which the refinancing rate and inflation levels in the economy of the neighbour state – the Republic of Kazakhstan are described with the same appearance. (Figure 4)
4-rasm. Indicators of the refinancing rates and inflation rates in Kazakhstan for 2001-2018
Source: drawn by the author
Looking at this graph, it is known that the situation in the economy of Kazakhstan is almost no different from ours. According to it, from 2001 to now, the refinancing rate set by the central bank has been regularly affected the level of inflation. Except for this, only in the period of the financial crisis of 2007-2008-th year. That is, as the economy of Kazakhstan relies mainly on oil, the price of global oil has fallen in the event of a financial crisis, whereas the internal price remained the same which led to high inflation. In the rest of the cases, the situation is the same: the refinancing rate is correctly correlated with the inflation rate.
In conclusion, any unreasonable advance increase of any instrument created to exchange commodities (whether in percentage or in another form) leads to an increase in the mass of money for the same period in the economy, and this leads to an increase in the level of inflation. But when the same artificially increased amount produces a self-justified equal value product or creates an alternative service, inflation may not be observed or may be significantly lower than the interest rate. Thus, the refinancing rate itself, which is set by the central banks, falls or, in rare cases, raises the value of money.
If the country removes the interest over the money in its financial system and allows the money to be increased only by the demand for the money, then money is used only for economic development and sharp changes in prices which are currently considered as the economic problem for the society would be eliminated in this way. And with this, the capital movement does not even stop, on the contrary, capital from abroad for large projects on account of macroeconomic stability begins to penetrate even more. Especially, Islamic assets standing today in the eyes of all world economists begin to come into. They are free from the financial bubbles that are the main cause of the financial crisis. By this way not only the government but also the whole society, muslims and non-muslims would succeed.
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Davlatyarov Olimboy Tohirovich,
a specialist at UZARO takaful company,
a former student graduated from the faculty
“International economics and management” of
the University of world economy and diplomacy
in Tashkent, in the Republic of Uzbekistan,
tel: +998 97 512-78-57, +998 90 187-30-21,