Raising interest rate does not always reduce inflation but at times leads to increase in inflation. Justify
There is no wonder why the measures initiated by RBI to curb inflation have not been successful in bringing down the Inflation.
Inflation means a sustained raise in the prices of commodities. The raise in prices could either be due to raise in costs (Cost-push inflation) or excess of demand over supply (demand-pull inflation). The central Bank of any nation, RBI in case of India, alters the interest rates in bank to curb inflation. The rationale is that, “Increase in interest rate would discourage borrowing of loans which in turn reduces the purchasing power of people. Reduction in purchasing power reduces the demand and the prices come down”.
Interest Rate- a Bane to Inflation!!!!!!!!!!
But the present scenario seems to prove this hypothesis wrong. Despite 12 times hike in the interest rate in span of 18 months, inflation has not subsided. The reasons for this anomaly could be summarized as below.
- Raising interest rates push up cost of production. The hardening of interest rate would result in higher cost of finance, resulting in higher EMI on the loans taken. This reduces the buying power of the customer. The reduced demand growth results in higher inventories leading to higher overhead cost per unit. The obvious consequence is raise in price
- Increase in interest rates lead to decline in profitability. This causes fall in stock prices. Continuously falling stock prices erode the capability of firms to raise funds at a lower rate of interest. Resort to the expensive sources of finance again spirals up the cost of production and prices in turn.
- Increased interest rates, as stated earlier, would lead to decline in demand growth for products and services. This would lead to a falling behind tax collection targets. The government, in its attempt to make good the loss in tax collection, increases tax and cess levied on petrol prices. Needless to say the result.
Other adverse effects of raising Interest Rates
- Reduction of tax revenues expand fiscal deficit. Raising prices demand higher subsides, again burden on public expenditure, more fiscal deficit.
- Higher interest rates and declined profitability leads to reduced viability for new projects and modernization of existing units. Domestic companies fall back foreign companies in technological advancement leading to further erosion of profitability.
- Increase in interest rate leads to reduction in demand for funds, both from buyers and manufacturers. Banks will have to put money in reverse repo thus reducing Net Interest Margin. Banks’ profitability will automatically erode.
- In aggregate, continuous interest rates will turn Inflation into Stagflation – a state of economy characterized by both inflation and Stagnation.
Questions
- Why is inflation unabated?
- What do you mean by stagflation?
- Give the meaning of demand pull and cost push inflation?
- Enumerate the relationship between inflation and interest rates.
- Raising interest rates push up the cost of production. Substantiate.
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2. Inflation refers to phenomenon where the prices of the commodities increase steadily. Stagflation refers to a phenomenon where inflation is at a high rate coupled with decrease in economic growth and increase in un-employment.
3. Demand pull inflation refers to an inflation (rise in prices of commodity) which is created by high demand of any particular product whose supply is less than the demand for it in the market. This leads to selling of that product for high prices because there will be competition among customers to acquire that product due to limited availability which in turn leads to paying high for the product than its original price.
Cost pull inflation refers to an inflation (rise in prices of the commodity) where in the prices of the product increases due to rise in the prices of raw materials, rise in cost of production, which increases the cost of the finished product.
5. Rise in interest rate results in high cost of production, because higher the interest rate the purchasing power of the customers will reduce and this leads to rise in inventory which adds to the overhead cost, automatically increasing the cost of production. And also rise in interest rate also leads to increase in the cost of raw materials which ultimately hikes the price of the products.
Dear vidya
your answers are right. very nice attempt. Try to articulate it bit critically. All the best vidya .
1) The economic slowdown due external factors (europian union crisis) and internal factors because of policy failure and lower investment sentiment has slumped the growth, resulting in inflation.
2) Stagflation means inflation with stagnation
3) Demand pull inflation means increase in prices of goods with increase in demand with no parallel increase in supply, thus causing inflation.
4) Cost push inflation means increase in cost of production which culminates in the rise in price of commodities.
5) Raising interest rate perpetuates lower investment which causes lower production of goods and also higher interest results in higher cost of production which again increases price of goods.
Dear keerthi
I must appreciate you wholeheartedly for your understanding of the concepts. Try to link concepts with current affairs.
All the best. Keerthi
Inflation: A persistent rise in the general level of prices of goods and services over a period of time.
Stagnation: Slow or no economic growth over a period of time.
Demand Pull Inflation: It is basically a mismatch between demand and supply, with the former exceeding the latter. Demand-pull Factors eg: rising population, rising per capita income, rising forex reserve
Cost Push Factor: The rise in the general price levels due to increase in the cost of production and distribution of goods in services. Cost Push factors eg: rising indirect taxes, Import cost push factor (rising international prices of petroleum products).
Reasons for inflation in India
1) Increase in Demand and fall in supply causes rise in prices.
2) Lack of Competition and Advanced Technology (increases cost of production and risein price)
4) Defective Monetary and Fiscal Policy
5) Hoarding (when traders hoard goods with intention to sell later at high prices)
6) Weak Public Distribution System
Given the fact that we are globally connected economy, where one country’s monetary policy has an effect on another country’s prices. Mere control through monetary policies (increase the bank rate) can’t help. We need global coordination to control inflation. We have to supplement our standard policies—with rather inclusive measures instead.
dear ravindra
answer is nice, but try to ennumerate the concept of stagflation in relation to unemployment.. coming to relation between inflation and interest rate , you have not attempted. try to attempt it. rest of the things are nice ravindra. all the best
Thanks Madam for presenting the “popular” view of how RBI’s tough stance of not changing key rates is also a factor leading to the Inflation.
While i second your opinion, i am also of the opinion that the other side of coin should also be looked at.
1. RBI had changed the limit of export credit re-finance from 15% to 50% in June 2012. ( which is believed to get more liquidity [upto 30,000 crore] into market and is also equivalent to 50 point CRR reduction). But we did not see any bank easing their interest rates after this change, even after RBI’s direction.
2. There are factors apart from higher interest rates (supply side bottlenecks, policy paralysis of Govt. leading to no improvement in the basic infrastructure of the supply side).
3. Slowdown in economy can not be blamed on RBIs policies, while multiple factors outside its purview are still dominant. Lower interest rates would not lead to sustained investment, unless complemented with policy related bottle-necks resolution. Current Account Deficit and Fiscal Deficit continues to swell.
4. Macro economic situations (inflation and growth both) leads to determining Monetary policy action.
RBI has time again said that it can play only a minimal part in taming the inflation and it is not responsible for the economic slowdown. while govt. continues to stay dormant, RBI alone can never win the fight againt Inflation and slowdown by itself.
Pankaj,
If i understand correctly the meaning of “Export Credit Refinancing”, it is aimed at encouraging exports and thereby strengthen local currency. It is not at an incentive for the banks to reduce interest rates, in fact, ECR is a kind of a loan given to banks at “Repo Rate”. It is equivalent to a cut in the CRR because the banks can have access to that much more cash.
So with an increase in ECR cap, practically there will not be any decrease in the interest rates.
Navya and Pankaj, correct me in case my understanding is wrong.
Yes Sandeep you are right. The only argument from the freeing up of money due to by changing the ECR was more availability of money to the banks, which in an ideal scenario could have been used to pass on some relief to the consumers and industry. But, even this indirect step of RBI did not help, as Banks did not heed to the call of RBI. Access money could not percolate to market.
In my opinion and limited knowledge while CRR is a direct way to releasing money, ECR modification and OMOs are indirect ways of infusing capital in market.
Pankaj,
I agree that ECR and OMO infuses money into the banking system but i think there are couple of factors which handicaps Banks to reduce the interest rates in terms of ECR:
1. Any Bank opts for ECR when it finds difficult to function with the existing cash reserve (because it would be waiting for the returns from the exporters-borrowers). Which means it will be suffering a loss out of the returns from these exporters-borrowers (i.e., Total Returns = returns from exporters – interest rate to be paid towards ECR borrowing)
2. Banks should payback the ECR to RBI whenever demanded or within a maximum time limit of 180 days.
There is a good article regarding OMO, http://articles.economictimes.indiatimes.com/2011-11-30/news/30458842_1_omo-open-market-operation-central-bank
dear pankaj bhat
your answer is really awesome.. i am happy that you have showcased the answer in another angle.. superb. good luck
Dear Navya,
I am a stranger to economics, hence I have few basic questions, could you please answer them in a simplified manner.
a. Decreasing the interest rates favours more borrowing of loans which leads to more production and hence meets the demand. Isn’t this reduction in inflation?
b. How does increase in interest rate push up the cost of production? The borrower pays back the money at higher interest, but the cost involved in producing goods would still remain the same right? Can you please elaborate on this.
c. What are stock prices?
d. “Banks will have to put money in reverse repo thus reducing Net Interest Margin”. Could you please explain this statement.
Regards,
Sathvik
Respected Ma’m
Thank you so much for this fabulous article on inflation as it cleared many of my doubts. Here, I would like to add few of my points, please correct me if I
Respected Ma’m
Thank you so much for this fabulous article on inflation as it cleared many of my doubts. Here, I would like to add few of my points, please correct me if I am wrong.
1. Wholesale Price index ( WPI) based inflation, especially food and fuel inflation is governed by many factors , some native while some are external, and as economic sectors are intangled by each other , so it also affects core inflation ( non- food manufactured product inflation) since any price rise in the value chain of the process will consequently increase the end marked price.
2. The Government on its part has taken austerity measures recently in the form of FDI in retail and increase in diesel price , thereby receiving large capital inflows and curbing subsidies, hence less cess on fuel items and a possible lowering of indirect taxes, hence less cost to the end user. Also, autonomous agencies like FMC ( Forward Market Commission) are examining reasons behind extraordinary surge in seeds prices.
3. Regarding RBI, it is restricting its monetary policy to the CRR cut. RBI is commended to choose a middle path since for monetary policy to be credible there cannot be softening of interest rates at this juncture. The CRR, by adding to liquidity, should induce banks to cut rates and lend more. With Narasimham Committee-1 suggested a sharp reduction in CRR and SLR; there has been question now whether CRR should remain an instrument of monetary policy , especially with a view to curb inflation. Yet these regulations are anyway important in countries like India where Open Market Operations (OMO) to check liquidity face some structural rigidities. It helps in curbing inflation by varying money supply in the market; may be it is not helping much in current senario due to low Industrial production and commerical banks less energetic steps to mobilize low cost savings and current account deposists and lending more to the customers. Moreover, NBFC and insurance companies which are not under compulsion to follow CRR norms are not helping much to ease inflation by giving easy and reliable credit to manufacturing units and customers.
Regards
Sumit
1.The high growth rates in last decade increased the average income of individuals. Global slowdown in 2008 had affected the exports badly and hence the value of money decreased. This decrement in value of money had lead to increase cost of imports. The rising cost of petroleum, which is the lifeline of economy , is primarily imported in our country and hence it had a “trickle-down” effect on other products and services.
To add to all those woes, growth has been badly hit. The slower growth rates in agriculture and production have also had its effect.
Hence, decreased growth, weakening of Rupee and global slowdown has lead to unabated inflation.
2.Stagflation is the condition where there is higher inflation rates, lower economic growth and steady increase of unemployment leads.
3. Demand-Pull Inflation: The rise in price when the demand outstrips the supply is called Demand-pull inflation.
Cost Pull Inflation: The rise price due to decrease in supply, due to increased cost of production leads, while demand stays high is cost pull inflation.
4. Monetary policies are often considered to affect inflation. Higher interest rates means it would be increase the cost of arranging capital. Since there will be less capital there would be less investment and lesser production. This would increase inflation .
Higher rates also mean that people will have less to spend and hence there will be decrease in demand and that would lead deflation. Although in growing economies decrease in demand is not a good sign.
Vice versa Lower rates means more capital and higher spending power. This would lead to sensible inflation where the consumers and producers both gain and supplement high economic growth.