This is how higher interest rates should counter inflation

The European Central Bank (ECB) is likely to raise interest rates for the first time in 11 years at the end of July. The bank does this, among other things, to combat inflation. But why is this happening? And how does a higher interest rate usually lead to less inflation?

Many European countries are experiencing the highest inflation in years. This is also the case in the Netherlands. Last month, life was 11.2 percent more expensive than a year earlier. In other European countries inflation is sometimes even higher. Last month Estonia had an inflation rate of 19.1 percent and in Lithuania it was 16.6 percent.

This inflation arose after the corona crisis, when major supply problems arose worldwide. The economic recovery after lockdowns also played a role in many countries. When the war broke out in Ukraine, inflation rose even further.

For a long time, the ECB was not in favor of raising the European policy rate. The bank stated that the high inflation had nothing to do with money policy in Europe. Only the above factors would affect inflation.

That will probably change this summer. The key interest rate, which is now at -0.5 percent, will probably be raised to 0 percent in two steps.

slow down the economy
The central bank does this because higher interest rates affect the amount of money consumers spend. Banks use the policy rate to determine the interest they charge their customers.

A higher interest rate makes it more expensive to borrow money. As a result, people borrow less money. Moreover, with a higher interest rate, people also save more.

Because of these two factors, people spend less money. As a result, the economy slows down.

When the economy slows down, general demand for goods and services falls. Because that demand decreases, prices rise less quickly. And as soon as prices rise less quickly, the inflation rate falls. This principle also works the other way around.

A little inflation is good for the economy
The ECB aims to keep inflation at 2 percent. In order to achieve this, the bank can therefore raise or lower the interest rate.

The bank has chosen that percentage because it believes that a little inflation is good for the economy. Gradually rising prices encourage consumers to spend their money.

The choice for 2 percent also ensures that deflation (the opposite of inflation) occurs less quickly. If prices fall, inflation will not immediately fall below zero. The 2 percent thus acts as a safety margin.