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.

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