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How are inflation rate and interest rate linked?

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Monetary Policy tools

Mains level : Not Much

The Monetary Policy Committee of the RBI has decided to keep the benchmark interest rates of the economy unchanged.

Try this PYQ:

Q.Which one of the following is not the most likely measures the Government/RBI takes to stop the slide of Indian rupee? (CSP 2019)

(a) Curbing imports of non-essential goods and promoting exports

(b) Encouraging Indian borrowers to issue rupee-denominated Masala Bonds

(c) Easing conditions relating to external commercial borrowing

(d) Following an expansionary monetary policy

What is the link between growth, inflation and interest rates?

  • In a fast-growing economy, incomes go up quickly and more and more people have the money to buy the existing bunch of goods.
  • As more and more money chases the existing set of goods, prices of such goods rise.
  • In other words, inflation (which is nothing but the rate of increase in prices) spikes.

How interest rates dominate?

  • To contain inflation, a country’s central bank typically increases the interest rates in the economy.
  • By doing so, it incentivizes people to spend less and save more because saving becomes more profitable as interest rates go up.
  • As more and more people choose to save, money is sucked out of the market and inflation rate moderates.

What happens when growth rate decelerates or contracts?

  • When growth contracts or when its growth rate decelerates, people’s incomes also get hit.
  • As a result, less and less money is chasing the same quantity of goods.
  • These results in either the inflation rate decline.
  • In such situations, a central bank cuts down the interest rates so as to incentivise spending and by that route boost economic activity in the economy.
  • Lower interest rates imply that it is less profitable to keep one’s money in the bank or any similar saving instrument.
  • As a result, more and more money comes into the market, thus boosting growth and inflation.

Why has RBI not raised interest rates this quarter?

  • RBI is facing an odd situation at present: GDP is contracting even as inflation is rising.
  • This is happening because the pandemic has reduced demand, on the one hand, and disrupted supply on the other.
  • As a result, both things are happening — falling growth and rising inflation.
  • It is true that for containing inflation, RBI should raise interest rates.
  • And under normal circumstances, it would have done just that. But raising interest rates at this stage would be catastrophic for India’s GDP growth.

Risks of altering interest rates

  • If the RBI cuts the interest rate, it may be fuelling retail inflation further. It must be remembered that inflation hits the poor the hardest.
  • So, the RBI has chosen to do what many expected it to do: stay put and waits for another couple of months to figure out how growth and inflation are shaping up.

Back2Basics: Monetary Policy Committee (MPC)

  • The RBI Act, 1934 (RBI Act) was amended by the Finance Act, 2016,  to provide for a statutory and institutionalized framework for an MPC, for maintaining price stability, while keeping in mind the objective of growth.
  • The MPC is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.
  • The meetings of the MPC are held at least 4 times a year and it publishes its decisions after each such meeting.
  • As per the provisions of the RBI Act, out of the six members of the committee, three members are from the RBI and the other three Members of MPC are appointed by the Central Government.
  • Governor of the RBI is ex officio Chairman of the committee.

Economics | Monetary Policy Explained with Examples

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