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.
- 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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