Do you ever wonder why there is so
much buzz around the eve of review of monetary policy by Reserve Bank of India
(RBI)? Why the businessmen want RBI to lower the interest rate? If you are
still perplexed, let us simplify this financial puzzle for you.
To begin with, monetary policy is a
set of decisions that RBI takes to control money supply in the market. The main
instrument used is repo rate i.e. the interest rate at which RBI provide money
to commercial banks. And the banks lend money at an interest rate that is directly
proportional to the repo rate. Now, the repo rate is dependent on the prevalent
level of inflation which is measured as percentage increase in price of
commodities with respect to a fixed period.
Furthermore, rate of inflation is
contingent upon income of the people and the business cycle. For instance, during
boom or period of business growth, increase in income leads to greater
consumption of goods and services which result in increase of their price i.e.
inflation. There is also concomitant growth of gross domestic product of the
country (GDP) i.e. total value of goods & services produced in a nation in
a fiscal year. GDP growth rate is also popularly known as economic growth rate
of a country and it is a quantitative metric.
On the other hand, economic
development is a holistic measure which reflects overall improvement in quality
of life vis-à-vis longevity, education, death rate, literacy rate, among
others. In other words, funds generated from higher economic growth are a
medium to achieve economic development.
Now that we learnt that there is a
link between interest rate and economic development, let us examine the
correlation between them. Suppose a scenario when RBI lowers the repo rate. It
will be followed by easy availability of loans at low interest rate and money
borrowed would be used for infrastructure development, business expansion,
technological advancement, etc. The profits generated will result in rise in
income and hence larger consumption of products in the market. Overall, it will
be reflected in higher GDP growth rate in short term and economic development
in the long term.
On the contrary, if RBI increases
repo rate to curb inflation, bank lending rate will also increase and there
will be shortage of money supply in the market that will dampen consumption
level. The businesses will undergo growth decline and consequent salary cut or
layoffs will reduce disposable income. Finally, the economy slows down and
nation development takes a hit due to paucity of money.
But the brighter side is that
people start saving money and they deposit it in the banks to earn interest on
the sum. After a certain period of low growth and controlled inflation, RBI
lowers the repo rate to spur investment in the market through bank lending.
Therefore, the cycle repeats as mentioned above.
We are hopeful that this
article has helped clarify your doubts regarding relationship between interest
rate and economic development. Stay tuned for information on similar topics!
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