Economics for Everyone - Interest Rates and Inflation
In essence the RBI announced no hike in CRR and a 25 bps (bps) increase in Repo rate but a 50 bps hike in Reverse Repo rate was not expected by many.
Prof.M.Guruprasad / 09:28, Aug 20, 2010
Recnetly the Reserve Bank of India raised the reverse repurchase rate to 4.5% from 4% and the repurchase rate to 5.75 from 5.5%. TheBank Rate has been retained at 6%. The cash reserve ratio (CRR) of scheduled banks has been retained at 6% of their net demand and time liabilities (NDTL).
The move was aimed to moderate inflation by reining in demand pressures and reduce the volatility of short-term rates, RBI governor Subbarao was quoted as saying. "Inflation is now being significantly driven by demand-side factors," Subbarao said. "It is imperative that we continue in the direction of normalizing our policy instruments to a level consistent with the evolving growth and inflation scenarios."
Highlights of RBI Monetary Policy Review for first quarter of the financial year FY2010-11
- The Bank Rate has been retained at 6.0%
- Repo rate increased by 25 bps from 5.5% to 5.75% with immediate effect
- Reverse repo rate increased by 50 bps from 4.0% to 4.50% with immediate effect
- Cash Reserve Ratio (CRR) of scheduled banks has been retained at 6.0% of their net demand and time liabilities (NDTL)
- The projection for WPI inflation for March 2011 has been raised to 6.0% from 5.5%
- Baseline projection of real GDP growth for FY2010-11 is revised to 8.5%, up from 8.0% with an upside bias
- M3 and non-food credit growth projections for FY2010-11 have been retained at 17% and 20% respectively
- Mid-quarter review of Monetary Policy to be a regular event beginning from 16 September 2010
- In essence the RBI announced no hike in CRR and a 25 bps (bps) increase in Repo rate but a 50 bps hike in Reverse Repo rate was not expected by many.
The RBI said that the Monetary Policy actions are expected to:
- Moderate inflation by reining in demand pressures and inflationary expectations.
- Maintain financial conditions conducive to sustaining growth.
- Generate liquidity conditions consistent with more effective transmission of policy actions.
- Reduce the volatility of short-term rates in a narrower corridor.
Impact of interest rates and inflation:
What impact does monetary policy have on the different interest rates in the economy and what effects it has got on the inflation rate? The RBI doesn't directly control these interest rates but in general a tighter monetary policy leads to higher interest rates.
So how do interest rates affect the rise and fall of inflation? Higher interest rates put less borrowing power in the hands of consumers (business).Thus consumers spend less; the demand slows down, thereby controlling inflation. If the RBI decides that the economy is slowing down -that demand is slowing down-then it can reduceinterest rates, incresing the amount of cash entering the economy (consumers/business).
Let us understand some of the concepts
- Monetary Policy-Interest rates (RBI, Bank rate, reverse repurchase rate, repurchase rate, cash reserve ratio CRR, Net demand and time liabilities NDTL, M3).
- Inflation (WPI,CPI)
- Relationsip between Monetary Policy and Inflation.
Thus the objective of the recent policy measures is to control the inflationary tendancy by increasing the interest rates.
Basic Economic Concepts RBI, Monetary policy, Interest rates and Inflation,
RBI:
Role of Reserve Bank of India: The regulation of the money supply and interest rates is done by a central bank, such as the Reserve Bank of India and Federal Reserve Board in the U.S., in order to control inflation and stabilize currency.
Establishment
The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934.
Preamble
The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."
Monetary Policy:
Monetary policy is one the ways the government can impact the economy. By impacting the effective cost of money, the Federal Reserve can affect the amount of money that is spent by consumers and businesses.
It regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks. The Monetary Policy aims to maintain price stability, full employment and economic growth. The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operations, control credit and vary the reserve requirements.
RBI’s conduct of Monetary Policy:
The RBI uses the interest rate, OMO, changes in banks' CRR and primary placements of government debt to control the money supply. OMO, primary placements and changes in the CRR are the most popular instruments used.
Interest rates: Interest rates measure the price of borrowing money. If a business wants to borrow Rs. 1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time. For example, if the bank loaned the money to the company at a 5% annual rate, the company would need to repay Rs. 1,050,000 at the end of the year. From the company's perspective, the value of that Rs. 1,000,000 right now is greater than the Rs.1,050,000 in a year (presumably because they have plans for the money), which is why they want to borrow it. For the bank, it is earning a 5% return on a one-year investment. Generally, there are two types’ ofinterest rates: floating and fixed. A floating rate, also called an adjustable rate, moves in step with a rate that is set outside of the lending institution, such as the prime rate (the rate at which banks lend to their best customers).
Repo (Repurchase) Rate: The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI.
The RBI raised the repurchase rate to 5.75 from 5.5%.A increse in the repo rate means banks get money at a higher rate than earlier and vice versa. The repo rate in India is similar to the discount rate in the US.
Reverse Repo rate: Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest.The RBI raised the reverse repurchase rate to 4.5% from 4%
An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.
Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI
Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system.
Net demand and time liabilities NDTL-include aggregate deposits, borrowings and other demand and time liabilities and not just aggregate deposits.
The cash reserve ratio (CRR) of scheduled banks has been retained at 6% of their net demand and time liabilities (NDTL).
Money Supply Measures
The RBI has adopted various concepts of measuring money supply. The first one is M1, which equals the sum of currency with the public, demand deposits with the public and other deposits with the public. Thus it includes all coins and notes in circulation, and personal current accounts.
M2, is a measure of money, supply, including M1, plus personal deposit accounts - plus government deposits and deposits in currencies other than rupee.
The third concept M3 or the broad money concept, as it is also known, is quite popular. M3 includes net time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.
Inflation:
An issue which has been causing grave concern to monetary authorities both in developed and in developing economies in recent years has been the phenomenon of inflation. Inflation can be described as a situation marked by a continuous increase in price level. The situation begins to cause worry when this increase in price level exceeds a tolerable limit. When prices increase they do not affect all sections of the society uniformly. When prices rise, some sections of society gain while other sections lose. The persistence of inflation also causes permanent damage to society. It diverts investment into channels like acquisition of land and other assets, which yield quick capital gains. When inflation continues over a period of time it also erodes the motivation for saving. However In controlling inflation the authorities must not only identify the causes but also must evaluate other side effects that may arise as a result of the pursuit of anti- inflationary policies.
Based on the source of inflationary pressures, it has been customary to distinguish three types of inflation, demand pull, cost push and structural.
Indicators and Measurement of Inflation:
Price Indices
Movements in prices have two aspects. One is the change in relative prices, which affect microeconomic resource allocation and the other in the overall price level, which affect the purchasing power of money over goods and services in general.
A variety of price indices are devised to capture this second aspect. IT is easy to measure changes in the prices of individual commodities, but how does one work out the overall price increase in a whole basket of commodities? This is what a price index does. There are three types of price indices viz., the Wholesale Price Index (WPI), the Consumer Price Index (CPI), and the GDP deflator.
The Wholesale Price Index ( WPI)
Measures changes in wholesale prices, it reflects producer inflation - the inflation facing producers in terms of inputs
And
Consumer Price Index (CPI)
Measures changes in retail prices and hence inflation as it affects the consumer.
GDP deflator
It is defined as the ratio of current price GDP to constant price GDP.
To construct the index for a given year, with reference to a base year we need
- Consumption basket in the base year
- Prices of the items in the basket in the base year and
- Price relatives for each item in the given year.
- From (i) and (ii) we can get the weights w1…wn.
Relationsip between Monetary Policy and Inflation.
The measured inflation rate at any point in time will be made up of an array of individual price changes. But the amount of inflation in the economy is about more than just the sum of all individual price changes. Something more fundamental determines the amount of inflation in the economy - whether it is 1%, 10% or 100%.
Inflation is usually generated by an excess of demand over supply.To contain inflationary pressures in the economy, demand needs to grow roughly in line with output. Output grows over time at a rate which largely depends on factors which increase productivity. If demand grows faster than this, unless there is spare capacity in the economy - such as after a recession - inflation is likely to rise.
One of the underlying causes of inflation is the level of monetary demand in the economy - how much money is being spent. We can demonstrate this by considering what happens when the prices of some products are rising. Imagine the price of cinema tickets has risen. If consumers want to buy the same amount of all goods and services as before, they will now have to spend more - because the price of one of the products they consume has risen. This will only be possible if their incomes are rising, or alternatively if consumers are prepared to spend a bigger proportion of their incomes and save less. But if total spending does not rise, then higher prices will mean consumers either will have to buy fewer cinema tickets or buy less of something else. Any fall in demand for goods and services will put downward pressure on prices. So although higher costs or other factors might cause some prices to rise, there cannot be a sustained rise in prices unless incomes and spending are also rising.
In general it is percieved that prices raise when more money chases few goods.Thus one of the key taks in controlling the inflation rate is to control the excessive money supply in the economy.
According to experts, by hiking the Reverse Repo rate, RBI has tried to lower the non-food credit off take which is currently at 22.3%. The current level of credit off take is higher than RBI’s projection of 20% for the year. The hike in Reverse Repo is 25 bps more than the hike in Repo rate. This step would lead to banks parking more money with the RBI.
In simple terms by increasing the interest rates say reverse repo and repo ( as in the current case), the RBI aims to increase the cost of borrowing money there by reducing the supply of money. This would impact (reduce) money that is spent by consumers and businesses.this would slow down the inflation.
Prof.M.Guruprasad,
AICAR Business School
[email protected]
9850981448