Certified Financial Management Specialist Practice Exam

What happens to inflation when interest rates rise?

1. Inflation increases

2. Inflation decreases

3. Inflation remains unchanged

4. Inflation becomes unpredictable

The correct answer is: Inflation decreases

When interest rates rise, inflation tends to decrease due to several interconnected economic mechanisms. Higher interest rates often lead to increased borrowing costs for both consumers and businesses. When borrowing becomes more expensive, consumers are likely to spend less, and businesses might hold back on investment. This reduction in spending and investment generally leads to lower demand for goods and services in the economy. As demand decreases, businesses may respond by lowering prices or slowing their price increases to attract customers, which contributes to a moderation of inflationary pressures. Additionally, higher interest rates can strengthen the currency, making imports cheaper and further aiding in the reduction of inflation. Overall, the relationship between rising interest rates and inflation is crucial in monetary policy, where central banks may raise interest rates specifically to combat high inflation levels, aiming to stabilize the economy by slowing down price increases.