When the Central bank (in India it’s RBI, in the USA it’s Federal Reserve System) raises interest rates, It’s a piece of big news. It can send ripples across the whole economy. It is the primary tool used by the central bank to manage inflation in the economy. In this article, we will try to understand why the central bank raises or cut down the interest rate in a simple manner.
What is the Interest rate?
If you borrow money, you will have to pay a little extra to the lender to make it worthwhile for the lender. This is the interest rate. The Interest rate is charged by the lender on the amount loaned. The interest rate is the amount charged on the principal amount by a lender to a borrower for the use of the asset. (The asset can be cash, any equipment, house, car, or any other assets). So, If you want to borrow money from the bank or any other lender, you would like to keep the interest rate as low as possible so that you don’t have to pay back much. On the other hand, You can earn more on your savings if the interest rate is high.
What is Inflation?
Inflation is the rise in the price of goods or services. It results in a decrease in the value of money. Let’s understand with a simple example:-
Let’s say if you purchase 1 kg of apple for Rs. 100 in year 1, if inflation hit the economy by say 8% per annum then the price of the same 1 kg apple will be Rs. 108 (simply 100+8 (8% of Rs. 100) in year 2. It means that you are not able to purchase 1 kg apple by paying the same amount Rs. 100. Likewise in an economy, prices of all the essential goods and/or services increase due to inflation. These can affect the economy in long term.
How interest rate helps in controlling inflation?
When central banks raise the interest rate, they are trying to control inflation.
Now let’s see how the interest rate helps in controlling excess inflation in the economy??
When the central bank change interest rates, the change spreads through the financial system and slows down the rate of inflation. Here’s how:-
- A rise in the interest rates from a central bank means that the commercial bank will earn more on its reserves. They might make more from keeping their money in a central bank than lending it out. So, if they do lend it out, they will raise their interest rates to make it worth their while. It affects consumers spending sentiment. More interest rates mean higher borrowing costs. Higher borrowing costs left less in the hand of consumers which is reducing their purchasing power, hence they spend less. when they spend less, business firms try to avoid increasing the prices of their goods or services and that’s how it leads to slowing the inflation which is the primary objective of central banks in raising interest rates.
- On the flip side, If the interest rate rises, savers earn more on their savings. It incentivizes people to save more and spend less. It again leads to slow inflation because of the “spend less save more” behavior of consumers.
- It is not only consumers who will tighten their purses, but the business house also. When the interest rate rises, the business will find it more expensive to borrow and invest the money, It means less economic activity. It might mean fewer jobs are created. Fewer Jobs and less wages could mean less money for households and consumer confidence might suffer, which also means less spending. Lower spending will translate into lower inflation.
- In India, the most famous interest rate is Repo Rate and Reverse Repo Rate. The Repo rate is the fixed interest rate at which the RBI provides overnight liquidity to banks against the collateral of Govt. and other approved securities. Repo (Repurchase Option). On the contrary, the Reverse Repo rate is the interest rate at which RBI absorbs liquidity on an overnight basis, from banks against collateral of eligible govt. securities.
- There is no single interest rate in India, rather there are many interest rates in India and they are mainly dependent on the repo rate as decided by the RBI. When RBI increases the repo rate, it means that banks will borrow less from RBI. It means liquidity will be low in an economy, with less money supply and leading to lower inflation. If banks borrow money from RBI to lend it further to the borrower, they will have to decide their lending rate based on the repo rate which obviously will be high because of the higher repo rate.
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