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 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.