The impact of higher interest rate on prices, output and employment

In response to rising inflation rate, the Bangko Sentral ng Pilipinas (BSP) raised its overnight reverse repurchase rate from 3.25 percent to 3.50 percent during its meeting last Wednesday. A similar increase was done only 6 weeks ago. Another increase might be coming soon if inflation prospects remain high.

A reverse repurchase agreement is the purchase of securities with the agreement to sell them at a specific future date. For the party selling the security (and agreeing to repurchase it in the future), it is a repurchase agreement (RP) or repo. For the party buying the security (and agreeing to sell it in the future), it is a reverse repurchase agreement (RRP) or reverse repo. The overnight repurchase rate is the BSP’s key policy rate which serves as a benchmark in the determination of other interest rates in the financial market.

With the recent increase in the BSP’s policy rate, we can also expect commercial banks to raise their lending rates and deposit rates. The nominal interest rate that banks charge us when we borrow from them consist of the real interest rate that they want to earn from us and the expected rate of inflation. If banks expect inflation rate to be 6 percent and they desire 6 percent in real return from us, they will charge us 12 percent in nominal interest rate. If after one year the actual inflation rate is 8 percent, the bank will now earn only 4 percent in real terms. They lose and their loss is our gain. However, if the actual inflation rate turns out lower, we lose.

Going back, the BSP is raising its key interest rate for the purpose of fighting inflation. How is this going to happen?

Individually, we buy many things daily to meet our consumption needs. Government buys a lot of things too for its own consumption and investments in infrastructure.

And so does business sector when they invest. Our personal consumption expenditures, government expenditures, and business investments, together with our net exports (exports less imports) when taken together comprise our aggregate demand. Our total output from agriculture, industry and services comprise our aggregate supply.

If from time to time, our aggregate demand matches our aggregate supply, the general price level will settle at a certain level. Inflation rate is zero. However, if aggregate demand exceeds supply, prices will rise. This may happen, for example, when from an equilibrium position aggregate demand has increased or aggregate supply has decreased. When prices are going up faster than the BSP’s target inflation rate (now at 2 to 4 percent), it may then act to counter inflation by reducing aggregate demand.

It does so by raising the interest rates. As we can see, high interest rates will discourage investments, including consumption, and thus reducing aggregate demand. When aggregate demand is lowered while supply remain constant, we can expect inflation rate to slow down. That is how it works. But then what about our output and employment?