Interest Rate as an Effective Tool for Regulating the Economy

Reserve Bank of India (RBI), the Central Bank in India, operates its monetary policies primarily by the set of interest rate. Therefore, interest rate policy plays an important role than ever before in economy. It is used as an effective tool for regulating the economy, dominating inflation and controlling investment and savings. In general, the Central Bank often changes the level or construction of the interest rate to achieve these goals.

The increase or decrease of interest rate causes the capital of enterprises go up or down respectively, which determines the expansion or narrowing of production. Therefore, it changes the number of jobs available. As a common payment method in the borrowing of enterprises from banks, credit rate has direct influences on unemployment situation in society and plays an important role to solve it.

The change in deposit rates, especially rediscount rate has direct effect on the amount of foreign currency flows into domestic market, thus affect the suppy and demand of foreign currency, which change the exchange rate and import-export relations in different periods.

To be more detailed, rediscount rate (an interest rate the State Bank imposes on commercial banks’s loans for their short-term or unusual cash needs) is concerned.

Every commercial banks have to calculate the ratio between cash and deposit (bank reserves) to meet the needs of their customers. They also have a ratio between cash and minimum safety deposit, which is set based on both the Central Bank’s regulations on required reserve and the business situation of the commercial banks. When the actual cash reserve ration of a commercial bank falls to slightly over the minimum safe rate, they have to consider whether to continue lending or not because of the possibility of unusual cash needs.

  • If the discount rate is lower than market rates, the commercial banks will continue lending until their cash reserves decrease to the minimum level allowed because even they borrow money from the Central Bank, they bear no loss.
  • If the discount rate is higher than market rates, the commercial banks do not let their cash reserves decrease to the minimum level allowd. They even have extra cash reserves to avoid borrowing from the State Bank with higher interest rates to meet unusual cash demand.

Therefore, with a certain monetary base, by setting the discount rate higher than market interest rates, the Central Bank is able to force commercial banks to have extra cash reserves, which lead to a decrease in money suppy. And when the Central Bank sets the discount rate higher than market interest rates, they will cause an increase in money supply.

There  is  always  a  force  to  push  the  banks  to  race  for  the  higher  deposit  and  loan amount, and to capture the bigger market share. To obtain high deposit amount, the bank may increase  the  interest  rate of deposit. With  the big  amount of deposit obtained,  the bank  can also offer good quality of loans, and gain more and more power on the lending side (in term of availability, flexibility and amount).  On  the  other  side,  to  release  the  captured  deposit,  the  banks  can  not  increase  the lending  interest  rate  too  high.  The  “price war”  of  interest  rate  is  always  a  danger  for  the banking  system,  because  it  deduces  the  margin  (lending  rate – deposit  rate – operation expenses) and it can lead the banking system to crisis.

Inflation domination

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. Annual inflation rate is reflected by the ratio of the increase in average price after a year.

When serious inflation occurred, the government tends to impose monetary policies in order to reduce the amount of money in circulation to keep the value of the currency. In this case, they usually push up interest rate. This method is also used to stabilize the price level among different areas, which help to promote production and goods circulating.

Following  the  quantity  theory  of  money,  as  the  interest  rate  increases,  the  money supply decreases, and the price tends to decreases to balance the equation of quantity theory of money. In addition, an increase in interest rate will cause both the consumption and  investment  demand  to  decrease  as  discussed  above,  which  results  in  the  decrease  of aggregate  demand  of  economy,  and  a  lower  equilibrium  price  can  be  expected  due  to  the move of demand curve to the left.  However, this effect seems to be short-term because the decrease of investment will finally result  in  the decrease of supply, which  in  turn moves  the supply curve to the left and bring the price back to the first equilibrium position.

Effect on investment and savings

In  respect  of  investment,  it  concerns  more  about  businesses,  who  increase  their investment  if  they  can  borrow money  at  low  REAL  LENDING  interest  rate.  On  the  other  side,  if  the  investment  is  high  (e.g.  in  booming economy),  banks  demand  more  money  by  increasing  DEPOSIT  rates,  while  increase LENDING  rates  to  compensate  and  get  profits  from  the  investors  (who  are  hungry  for money).  Collectively,  a  low  real  interest  rate will  boost  consumption  and  investment, which results  in  the growth of  [HOT] economy; while a high  real  interest  rate  tends  to COOL  the economy.

If the REAL DEPOSIT interest rate is high, people tend to save more money in deposit, rather than spending.  On the other side, if the consumption is high, the income available for saving is low, and the banks have to increase deposit interest rate to get more deposit.