Question bank 5.5

[ST6_aspirant]

Macroeconomic section of this answer says:

It might be argued that high (low) inflation is associated with high (low) real interest rates, and that this can be unfavourable (favourable) for economic growth and hence equity prices.

But real interest rate = nominal interest rate - inflation

So how is high (low) inflation is associated with high (low) real interest rates?

 

[Matthew_Law]

High inflation gives the government/central bank pressure to increase the real interest rate such that consumer spending will fall and lead to lower inflation level due to:

1. higher borrowing cost
2. higher cost to service debts
3. saving becomes more attractive

High inflation also related to greater uncertainty over future inflation, higher debt servicing costs leads to greater risk of company default. Both would contribute to greater equity risk premium and lower equity price.

 

[ST6_aspirant]

Understood it well. Thank you.