Page 34 - Banking Finance July 2020

ARTICLE

How interest rates are used to control Is rate cut by RBI during Covid-19 really

inflationary economy: helping to upturn the economy:
Inflation refers to the rate at which the prices of goods and As we all are aware that due to spread of Covid-19 pandemic
services rise. Interest rates and inflation are closely related and the lockdown the large economies worldwide have
to each other and often referred together.Inflation occurs taken a hit and India is no exception. To boost the economy
when an economy grows due to increased spending. When Government announced many stimulus packages, and the
this happens, prices rise and the currency within the central bank has not remained behind. Along with extension
economy loose its value. The currency essentially won't buy of repayment moratorium to the borrowers the RBI has
as much as it would before. stepped up to the plate at the right time with measures of
rate cuts that will reduce the cost of capital and ease the
One popular method of controlling inflation is through a financial burden on businesses due to the extended
contractionary monetary policy and as we have discussed lockdown.
earlier controlling interest rates is one aspect of monetary
policy. The goal of a contractionary policy is to reduce the With latest repo rate cut of 40 basis points on 22nd May,
money supply within an economy by decreasing bond prices the RBI has shaved off 1.15 percentage points from the rate
and increasing interest rates. By raising interest rates such chart in less than two months since the lockdown began on
as Repo, the RBI causes banks to raise rates (as we discussed 24th March, bringing the repo rate down to 4% and the
the lending rates are directly linked to repo now) and thus reverse repo rate to 3.35%. With this, it does appear that
lowers demand. Firms do not borrow as much to invest when the central bank may have played out its rate cut card for
rates are higher and individuals stop buying durable goods now.
against credit and, instead, turn to save. Also a higher
reverse repo provides the banker with an risk free But the question arises that is it really helping? In fact, it is
investment option with higher return so they tend to lend believed that the latest cut may be no more than a
less. Lower demand growth leads to a better match sentiment booster as economic activity is at its nadir and
between demand and supply, and thus lower inflation. there are not many loan proposals lying with banks that may
benefit from the lower interest rate. Fresh lending by banks
How interest rates stimulate economy are at its lowest levels. On the other hand to maintain asset
during recession: liability balance banks will cut deposit rates which will result
into lower returns on their investments to depositors.
During a recession, unemployment rises, and prices
Existing borrowers may be the only beneficiaries of the rate
sometimes fall in a process known as deflation. At the onset
cut at this point in time. Once the lockdown ends, economic
of a recession, some businesses begin to fail typically for activities start to get going then this rate cuts may play the
economic bottlenecks that result from the incompatibility
pivotal role to upturn the economy.
of production. These businesses lay off workers, sell assets,
and sometimes default on their debts or even go bankrupt.
References:
All of these things put downward pressure on prices and the
The speech of Dr Raghuram Rajan, Ex RBI Governor at
supply of credit to businesses in general, which can spark a
process of deflation. National Council of Applied Economic Research in January
2016
Then the central bank in its monetary policy announce rate Text book of CFA level 1 on Quantitative Methods, chapter
cut which lower the interest rates. Lower interest rates on time value of money, topic: explanation of interest rate.
enable the businesses to borrow low cost funds and sustain
Economics Textbook by Samuelson Nordhaus, Chapters on
their activities. This also enable consumers to make more Inflation and Monetary Policy in Macroeconomics
purchases on credit, keeping consumer prices high and
likewise extend themselves further into debt rather than live Newspaper: Economic Times Online, Publication on RBI rate
within their means. So money supply increases, businesses cut on 22nd May 2020
retain their employees and recession tends to go away. Websites: rbi.org.in, investopedia.com T

34 | 2020 | JULY | BANKING FINANCE