Interest rates vs Inflation

"In the quarterly review of the Monetary Policy which was announced yesterday, the Reserve Bank of India (RBI) has increased interest rates; repo rate up by 50 basis points and the Cash Reserve Ratio by 25 basis points. All of these measures have been announced to tame inflation which is currently around 12%. The RBI also made it clear that controlling inflation was a higher priority than fuelling growth and are happy to rationalize the growth expectations to 8%."

Doesn't that look familiar? Indeed it is. The newspapers are filled with articles everyday about how how the ever-increasing inflation is taking its toll on the economy and how RBI is trying to curb it by varying the interest rates.It would be interesting to see how the variation in interest rates affect the inflation. Let's delve deep into it.

Inflation is the rise over time in the prices of goods and services.Greater the inflation,lesser would be the value of your money.In layman terms, if you could get something for X rs. a year back,due to inflation you would be getting the same thing for (X+Y) rs. after some time , where Y is the extra amount to be paid due to inflation.Inflation is heavily dictated by the demand-pull theory.When too much money chases too few goods ,then the inflation rate increases.

So,the big question is how does the interest rate control the inflation? When the interest rates are smaller,it puts more borrowing power in the hands of consumers.And when consumers spend more, the economy grows, naturally creating inflation. If the interest rates are low ,then people borrow for a variety of reasons like home loans,car loans etc. Thus, because of the lower interest rates ,money tends to be in plentiful supply.Thus,for limited supply of resources, there is a high demand.This leads to increase in the prices of the commodities and hence inflation rate increases.

Therefore,to control inflation the interest rates are increased.A customer who was eager to borrow at 6% interest rate,would be less eager to borrow at 9% interest rate.Thus,by increasing the interest rate the borrowing power of the public is decreased.As a result of limited supply of money now,the demand for the resources decreases and hence the prices decrease.

Thus, interest rates play a very crucial level in determining the inflation in the economy.

Preface..

Hi all,

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