How Does Inflation affect Interest Rates?
How Does Inflation affect Interest Rates?
Central Banks across the world use interest rate as a primary instrument to control inflation.Simply put:Inflation can be defined as the sustained increase in the general price levels of an economy.On the other hand;interest can be defined as the cost of borrowing funds.This blog discusses how interest rate is used as an inflation control method.
The use of interest rate to control inflation is different in different situations.Let us discuss two main situations:
High Inflation:
To control high inflation :interest rate is increased .A rise in interest rate will make borrowing funds expensive.As a result; borrowing will decline:which in turn will lead to a fall in the money supply (i.e the amount of money in circulation in the economy). As the amount of money in circulation declines;people will have lesser amount of money in hand to spend and hence they will buy less amount of goods and services.This,in turn, will lead to a fall in the demand for goods and services.With the supply remaining constant and the demand for goods and services declining ;the price of goods and services will fall.As inflation is a continuous increase in the general price level of goods and services so a fall in the general price level of goods and services will lead to a decline in inflation levels.
Low Inflation:
In low inflationary situations;the interest rate is reduced.A decline in interest rate will make borrowing of funds cheaper.As a result borrowing will increase and subsequently the money supply will increase.As the amount of money in circulation increases;people will have more money to spend on goods and services.Consequently;the demand for goods and services will increase; with supply remaining constant this leads to a rise in the price level i.e inflation.
An Example:
In the fourth quarter of 2016,RBI reduced the Repo rate by a quarter of a percentage point (i.e by 0.25%)from 6.50 per-cent to 6.25 per-cent in the light of low inflation.India’s retail inflation fell from 6.07% to 5.05%(from July to August in 2016).Repo rate can be defined as the rate at which commercial banks borrow from RBI. A decline in Repo rate will lead to a fall in the commercial bank’s cost of funding.Now in India;all loans having a flexible interest rate ;including home loans taken after April 1.2016; are tied to the bank’s MCLR(Marginal cost of funds based lending rate) while the pre-April borrowers have their loans tied to the bank’s base rate.As a result of reduction in the cost of funding and the huge inflows of deposits as a result of demonetization ;many Indian banks reduced their MCLR. SBI reduced its MCLR by 90 basis points with the current six month MCLR being 7.95% .Other banks such as PNB also reduced their one year MCLR to 8.45% from 9.15% (i.e a 0.27%).This reduction in MCLR will lead to an increase in loan growth in both retail and corporate segment.This increase in loan growth will have a positive impact on the economy by increasing the demand for goods and services(as people will now have more money to spend).RBI expects that this move will lead to an increase in inflation thereby bringing the inflation to the target of 5% by March 2017.
Thus interest rate is a quite effective instrument in controlling inflation.
Central Banks across the world use interest rate as a primary instrument to control inflation.Simply put:Inflation can be defined as the sustained increase in the general price levels of an economy.On the other hand;interest can be defined as the cost of borrowing funds.This blog discusses how interest rate is used as an inflation control method.
The use of interest rate to control inflation is different in different situations.Let us discuss two main situations:
High Inflation:
To control high inflation :interest rate is increased .A rise in interest rate will make borrowing funds expensive.As a result; borrowing will decline:which in turn will lead to a fall in the money supply (i.e the amount of money in circulation in the economy). As the amount of money in circulation declines;people will have lesser amount of money in hand to spend and hence they will buy less amount of goods and services.This,in turn, will lead to a fall in the demand for goods and services.With the supply remaining constant and the demand for goods and services declining ;the price of goods and services will fall.As inflation is a continuous increase in the general price level of goods and services so a fall in the general price level of goods and services will lead to a decline in inflation levels.
Low Inflation:
In low inflationary situations;the interest rate is reduced.A decline in interest rate will make borrowing of funds cheaper.As a result borrowing will increase and subsequently the money supply will increase.As the amount of money in circulation increases;people will have more money to spend on goods and services.Consequently;the demand for goods and services will increase; with supply remaining constant this leads to a rise in the price level i.e inflation.
An Example:
In the fourth quarter of 2016,RBI reduced the Repo rate by a quarter of a percentage point (i.e by 0.25%)from 6.50 per-cent to 6.25 per-cent in the light of low inflation.India’s retail inflation fell from 6.07% to 5.05%(from July to August in 2016).Repo rate can be defined as the rate at which commercial banks borrow from RBI. A decline in Repo rate will lead to a fall in the commercial bank’s cost of funding.Now in India;all loans having a flexible interest rate ;including home loans taken after April 1.2016; are tied to the bank’s MCLR(Marginal cost of funds based lending rate) while the pre-April borrowers have their loans tied to the bank’s base rate.As a result of reduction in the cost of funding and the huge inflows of deposits as a result of demonetization ;many Indian banks reduced their MCLR. SBI reduced its MCLR by 90 basis points with the current six month MCLR being 7.95% .Other banks such as PNB also reduced their one year MCLR to 8.45% from 9.15% (i.e a 0.27%).This reduction in MCLR will lead to an increase in loan growth in both retail and corporate segment.This increase in loan growth will have a positive impact on the economy by increasing the demand for goods and services(as people will now have more money to spend).RBI expects that this move will lead to an increase in inflation thereby bringing the inflation to the target of 5% by March 2017.
Thus interest rate is a quite effective instrument in controlling inflation.
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