Certified Financial Management Specialist Practice Exam

How do interest rates generally relate to inflation?

1. Interest rates rise with inflation

2. Interest rates fall when inflation rises

3. Interest rates have no impact on inflation

4. Interest rates and inflation are inversely related

The correct answer is: Interest rates rise with inflation

Interest rates are closely related to inflation because they reflect the cost of borrowing money and the return on savings. When inflation rises, the purchasing power of money decreases, meaning that lenders need to be compensated for the declining value of the money they lend. This is often achieved by increasing interest rates. Central banks, such as the Federal Reserve, typically respond to rising inflation by raising interest rates to discourage borrowing and spending, which can cool off inflationary pressures in the economy. This relationship underscores the importance of managing inflation expectations, as higher inflation expectations can lead to higher nominal interest rates. The other options present misconceptions about this relationship. For instance, the idea that interest rates fall when inflation rises does not align with the typical central bank response to excess inflation. Similarly, claiming that interest rates have no impact on inflation overlooks the fundamental ways in which monetary policy influences economic activity. The assertion that interest rates and inflation are inversely related is also incorrect, as they often move together, especially in the context of central banking policies aimed at stabilizing prices and economic growth.