What is the consequence of permanent inflation for the interest rates?

Inflation is the rate at which the general price level in an economy is increasing over time. When we talk about permanent inflation, it means that the price level keeps rising continuously without any signs of slowing down or stopping. This can affect various aspects of the economy, such as purchasing power, savings, investments, and interest rates.

The Fisher Effect is an economic theory that describes the relationship between inflation and nominal interest rates. It states that the nominal interest rate is the sum of the real interest rate and the expected inflation rate. Mathematically, we can represent this relationship as follows: \[ i = r + \pi \] Where: \( i \) = nominal interest rate \( r \) = real interest rate \( \pi \) = expected inflation rate

As per the Fisher Effect, when there is a permanent increase in inflation, the expected inflation rate (\( \pi \)) also increases. This increase in the expected inflation rate will result in an increase in nominal interest rates (\( i \)). This is because lenders will demand higher interest payments to compensate for the erosion of purchasing power due to higher inflation, and borrowers will be willing to pay higher interest rates as they expect their income to increase due to inflation.

The consequence of permanent inflation on real interest rates is less direct than on nominal interest rates. Real interest rates represent the true cost of borrowing or lending, adjusted for inflation. The actual impact on real interest rates depends on various factors such as monetary policy, economic growth, and market expectations. In some cases, permanent inflation can lead to higher real interest rates if the Central Bank decides to tighten monetary policy to combat inflation. In this case, the nominal interest rate might increase more than the inflation rate, resulting in a higher real interest rate. On the other hand, if the economy is growing, and businesses have higher profit expectations, the demand for loans might increase, pushing the real interest rate down. In such cases, real interest rates can be relatively stable or even decrease despite permanent inflation.

In conclusion, the consequence of permanent inflation on interest rates is that it leads to an increase in nominal interest rates, as described by the Fisher Effect. However, the impact on real interest rates is more complex and depends on various factors such as monetary policy, economic growth, and market expectations.