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Nov 07, 2014 12:11 pm
INFLATION VERSUS GROWTH

Recently Hon. Finance Minister made another call to drop the Repo rate for Government to speed up growth.

This, in itself, leads to a debate and perhaps divided opinions as so far the RBI has been increasing Repo rates to control inflation.

 

How does the Government particularly the RBI control Inflation?

RBI defines what is known as the “Repo” rate – this is the rate at which RBI lends to other Banks. Quite obviously, the rate at which the Bank in turn would lend to its customers will depend on this and be higher than the defined Repo rate.

Conversely if the Bank were to park money in RBI it would get interest at what is known as the “Reverse Repo” rate.

Current Repo rate is 8% and after Mr.Raghuram Rajan has taken over as Governor RBI, this has undergone 3 increases.

 

What happens when the RBI raises Repo rate:

  • Banks borrow from RBI at higher rates
  • They charge higher rates to the end consumer – people like you and me
  • So your home loan or car loan EMI becomes more
  • Money available to you to spend on food, groceries etc. becomes less
  • You cut down on expenses
  • Aggregate demand goes down
  • Given same supply levels, the prices will fall if demand goes down
  • Hence fall in prices OR no price rise = lower Inflation

 

Demand decrease versus Supply increase:

However, there is a counter argument that if it is a demand versus supply issue, then the other alternative could be to actually increase supply. This can be done by

  • Increasing production
  • Improving logistics so that all goods reach the market

Do recall that the onion price rise about a year ago was more to do with supplies not reaching the market rather than a sudden spurt in demand

 

Has the RBI measures succeeded?

Yes, to a large extent it has. WPI Inflation, which is based on whole sale price, has gone down below 3% and the CPI or consumer inflation is also down below 6%. But these levels need to be maintained.

 

What is the flip side of Rate increase?

If you follow the cycle post repo rate increase you will realise that decreased disposable incomes=decrease in demand. Over a period of time supply or production would naturally re align itself with demand.

So, if supply decreases, it means production has fallen and therefore growth.

So a rate increase would suppress growth as a fall out, if it is done in isolation.

Conversely, a fall in Repo rate will mean a rise in growth as well as inflation.

 

India’s dilemma:

We wish to increase growth from 5% levels to 7-8%. At the same time we want to consistently have WPI inflation below 6%. This means Repo rate or RBI’s monetary policy cannot be viewed in isolation as a means of reducing Inflation alone.

Apart from Repo rate the Government will and has taken measures on:

  • Increasing investments
  • Encouraging manufacturing in India
  • Removing logistics and supply chain bottlenecks
  • Overall ease of doing business

We hope that as a nation our GDP growth will remain higher than Inflation!

 

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