One of the fascinating issues in economics is how the amount of money you and I and everyone else spend each day and week has a huge impact on the inflation rate.

If, for whatever reason, we ramp up our spending to an excessive level, say as Australians prepare for Christmas, inflation will rise. The reasons for excessive spending can be due to the fact we have plentiful savings, our level of wealth has risen, pay rises are common and large or we have an ability and willingness to borrow lots of money, to name a few.

Excess spending can lead to high inflation because the businesses we go to when we splash our cash see that their sales are strong. As a result, they will try to – and usually succeed – in putting up their selling prices without there being any loss in sales, such is the consumer exuberance and willingness to spend.

We consumers don’t mind paying the extra price businesses charge because we are feeling flush with cash and need to satisfy our demand for the goods and services on offer.

In these circumstances, which lead to high inflation, the Reserve Bank (RBA) will respond by hiking interest rates to dampen consumer optimism and spending as we allocate more cash to servicing debt.

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It is noteworthy that inflation can also rise because the cost of business inputs rise – materials, rents, wages and even interest rates can add to the cost of running a business. For a firm to retain its profitability in these circumstances, it has to pass on these higher prices to consumers to remain solvent. A firm cannot stay in business for very long if its costs exceed its selling prices. And no one wants that.

Lower demand lowers inflation

In terms of the first cause of inflation - excess demand - the purpose of higher interest rates is to force consumers to scale back their spending and to boost their savings.

For the roughly one-third of households with a mortgage, higher interest rates divert their cash flow towards interest payments and servicing their debt, which means less can be spent more directly in the economy. High interest rates also make it more attractive for those with savings to earn a higher interest income.

It is always a difficult judgement for the RBA and markets to know what level of interest rate is effective in dampening spending to the exact extent that sees business scale back price increases and offer discounts without too much in the way of collateral damage in the form of higher unemployment.