Based on Sushma's comment on an earlier post, I thought of elaborating on the relationship between the three basic economic measures - inflation, interest rates and growth rate. Inflation, as everyone knows, is the rise in prices of goods and services. There are various factors contributing to inflation, and one among them is the excess supply of money in the economy. Central banks (RBI in our case) use 'Monetary Policy' to control money supply and thus inflation. In order to control money supply, RBI can resort to one of (or all of) the following actions: (a) open market operation, where it sells bonds and thus absorbs money from the market; (b) increase in interest rates (the rate at which it lends to banks), thus making the borrowings costlier for banks; and (c) increase in reserve requirements (percentage of deposits the banks are required to maintain with RBI), which leaves lower amounts of loanable funds with banks. In all the above cases, the excess liquidity is sucked by RBI in order to reduce the inflation.
When banks are asked to pay higher interest while borrowing from RBI and are left with lesser amounts of loanable funds, they start charging higher interest rates on their loans. This makes bank loans costlier. On one side the individuals will borrow less amounts of money and thus reduce their demand for goods and services; whereas on the other side, with higher interest rates, they would start investing more in banks/govt bonds etc.
But every economic action has a flip side. When the central bank tries to control inflatilon, beyond a point, through tight monetary policy, demand for goods and services comes down heavily as the loans become unaffordable. For example, when the interest rates are high, demand for housing comes down. On the other hand, the industry will put its expansion plans on hold as the borrowed capital becomes costlier. This reduces the overall economic activity of production of goods and services and thus the growth rate of the economy (measured in terms of GDP growth) slides down. So, beyond a point, you control inflation by compromisng the growth!
When banks are asked to pay higher interest while borrowing from RBI and are left with lesser amounts of loanable funds, they start charging higher interest rates on their loans. This makes bank loans costlier. On one side the individuals will borrow less amounts of money and thus reduce their demand for goods and services; whereas on the other side, with higher interest rates, they would start investing more in banks/govt bonds etc.
But every economic action has a flip side. When the central bank tries to control inflatilon, beyond a point, through tight monetary policy, demand for goods and services comes down heavily as the loans become unaffordable. For example, when the interest rates are high, demand for housing comes down. On the other hand, the industry will put its expansion plans on hold as the borrowed capital becomes costlier. This reduces the overall economic activity of production of goods and services and thus the growth rate of the economy (measured in terms of GDP growth) slides down. So, beyond a point, you control inflation by compromisng the growth!
Elaborating to what Prof. M Ajoy Kumar has said,when a country is flying high in its economic growth, opportunity for investment would be very high. Undeniably demand for money would also rise and if continue to do so, it would lead to inflation. So, RBI steps in and rise the interest rates. It does it to curb the borrowing power of people.
ReplyDeleteVivek..you are right. But it seems we are on the reverse track now. With estimated growth rate below 7%, the hike in interest rates by RBI seems to have brought in more unintended results than what was expected. The inflation continues to be a botheration, while the economy is slowing down. Now people are asking RBI to reduce the rates!
ReplyDeleteControlling flow of money is the one side of inflation, which RBI has practiced from years now. But, another major factor which can provide a check to inflation is the supply factor.
ReplyDeleteI had recent interaction with Mr. Ullas Rele, ex treasure of Oman bank. He had a opinion that beyond a limit controlling inflation through monetary policies becomes difficult and govt needs to concentrate more increasing the supply of goods to check inflation.
Thank you Khazi for your inputs. In fact Dr. Subba Rao, Governor of RBI had to say the same while delivering an invited talk sometime back. He was stressing that RBI could go only upto a point in controlling inflation using monetary policy. Supply side measures, especially in agricultural commodities, was very crucial for containing inflation. But I feel the supply side measures take a bit longer to implement as well as to get reflected in prices. That being the case, monetary policy becomes the immediate solution.
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