Inflation and Interest Rates

Think of a balloon. A hot air balloon. Rise in inflation causes it to ascend, and to keep it in check, interest rates have to be increased to cool things down and to bring back the balloon(economy) into a "safe" altitude. This is the very basic relationship between inflation and interest rates.

So what causes the rate of inflation to increase? Truth is, I could spend a page and a half discussing it from the point of view of classical or Keynesian viewpoints of economics and still not finish. But i think I'd just put a general summary found on wiki for you:

• Demand-pull inflation: caused by increases in aggregate demand due to increased private and government spending, etc.
• Cost-push inflation: AKA "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, E.g, a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
• Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" as it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

In general, I would say that an increase in the rate of inflation would be due to more than one of the above mention factors.
So how do governments deal with inflation? There are basically two methods, a Fiscal policy and Monetary policy.

Fiscal is about injecting money into the economy and creating demand for consumption by way of handouts and tax rebates, by printing more money or borrowing from the people.

Monetary policy is about controlling the amount of money in the market. Buying back government bonds causes an increase the money supply leading to lower interest whereas bond issues decrease money supply which increases the interest rate.

Okay.. I think I've covered the very bare minimum of inflation and interest rates. Though it seems really boring, I feel that it is a post that has to be written before I go on to write more in depth stuff.

So to reiterate the hot air balloon imagery... if the balloon goes too high, the bubble will burst! And it will come spiralling down.

Brain teaser which I had to think about recently:
The hot air balloon you are in has a hole and is sinking fast towards shark infested waters. There are ten people in a hot air balloon:
A policeman with a gun with live bullets
A couple with a 10mth old baby
A pregnant lady
A pilot
An engineer
A businessman with $100m cash
An artifacts dealer with a painting worth $5m

One person has to jump so as to ensure the survival of the rest. Who would you pick? why?