Relation between Inflation and Bank interest rates: How does inflation affect rates?

• Inflation, in simple terms is a sustained increase in general price level.
• In other terms it can also be described as a situation in which excess money chases fewer goods, causing increase in demand of goods and thus leading to an increase in price.
• Thus if this demand created by excess money can be curtailed, inflation would be contained.
• This is the genesis behind controllin inflation through monetory policy.

How the inflation is controlled?

• If inflation occurs interest rates are increased (ie)
• Both Repo and Reverse Repo rate in increased.
• If repo rate is increased, rate at which banks borrow from RBI is increased, and so borrowing will become costly and banks would thus either borrow less or pass on this increased to their borrowers.
• Simultaneously, Reverse repo rate is also increased, which tends to divert more funds to Central bank(RBI) and excess liquidity will be absorbed by RBI rather than going at cheaper cost in the economy.
• In either of the cases, actual lending will be less and demand for goods and services will be less.

By this money flowing is decreased in the country and to the people.