Inflation refers to rise in prices of goods and services over a certain period. Higher inflation makes goods and services expensive, ultimately impacting finances. The rate at which these prices rise is the inflation rate. On the other hand, interest rate refers to the price of borrowing money from banks or the returns on savings. As part of financial planning, it is also essential to understand these terms and the way inflation and interest rates are related.
What is inflation and what are its causes?
Inflation is defined as the overall rise in the prices of goods and services over time. It diminishes the purchasing power. Some of the causes of inflation are:
- Imbalance in supply and demand: Inflation rises when demand for goods and services rises, but supplies are limited at desirable price levels.
- Production costs: Increasing production costs, including expenses related to labour, raw materials, and energy, can lead to inflation. Businesses may pass on these costs to the consumer, resulting in high prices.
- External shocks: Disruption in supply owing to unexpected events, such as natural disasters, geopolitical conflicts, or changes in global markets, can disrupt the normal functioning of an economy and result in an increase in prices.
How is inflation measured?
Inflation is measured with the help of different economic indicators, such as the Wholesale Price Index (WPI) and Consumer Price Index (CPI).
- Consumer Price Index (CPI): The RBI now uses CPI to measure inflation rates in the economy. This indicator tracks changes in the prices of a basket of goods and services consumed by an average household. The index indicates how the cost of living for consumers changes over time. The CPI rises when there is inflation.
- Wholesale Price Index (WPI): Changes in prices in WPI are measured from the wholesale level while they are measured at the retail level in CPI. The WPI was used to measure inflation up to April 2014. WPI considers the change in the price of goods only, while CPI considers the change in the process of both goods and services.
Types of Inflation
- Demand-Pull Inflation: This type of inflation is caused when the aggregate demand exceeds aggregate supply, creating upward pressure on prices. Demand-pull inflation, usually associated with economic booms, occurs in a situation where there is an increased collective demand from consumers and businesses for more goods and services than the economy can produce.
- Cost-Push Inflation: Cost-push inflation can occur due to various reasons and mainly driven by an increase in production costs due to rising wages or surges in the prices of raw materials.
- Built-in Inflation: This type of inflation, also known as wage-price inflation, takes place due to a self-reinforcing cycle. It begins when workers demand higher wages to manage higher living costs. As businesses raise wages, they, in turn, increase prices to offset the higher labour costs. This cycle can perpetuate inflationary pressures.
How does inflation impact finances?
- Erode purchasing power: The rise in prices of goods and services over time may reduce the purchasing power of consumers as lesser goods will have to be purchased with a fixed amount of money. For example, one could have bought two meals with Rs 1,000. However, due to inflation, the same amount of money may not buy them a meal, and instead, one meal may cost Rs 1,200.
- Income redistribution: Inflation disproportionately affects lower-income consumers who tend to spend a higher proportion of their income on necessities than those with higher incomes. They will have lesser cushion against the loss of purchasing power. Moreover, people with a fixed income, such as salary may have to deal with rising costs. On the other hand, those whose money is connected to prices, such as owning a business, may make more money.
Interest rates
Interest rates denote the cost of borrowing money or the return on investment for lending capital and influence financial decisions related to spending, saving and investment. Interest rates are of two primary types:
- Nominal interest rate: It refers to the stated interest rate on a loan or investment, denoting the actual cost of borrowing or the return on investment before factoring in inflation.
- Real interest rate: This type of interest rate is an accurate measure of the cost of borrowing or the return on investment as it refers to the nominal interest rate adjusted for inflation.
According to the Fisher equation, the relationship between nominal interest rates, real interest rates and expected inflation are explained by the formula below:
Real interest rate = Nominal interest rate − Inflation rate
Interest rates and role of RBI
Central banks, such as the RBI play a crucial role in regulating interest rates for fulfilling various economic objectives.
- Monetary policy: Monetary policy tools are used by central banks to control the money supply and influence interest rates. Regulating the policy rates, such as the repo rate in India impacts borrowing costs.
- Inflation targeting: Central banks target a specific inflation rate and focus on keeping inflation within a target range by adjusting the interest rates. Lower rates boost economic activity whereas higher rates mitigate inflationary pressures.
- Economic stability: Interest rates are applied to achieve economic stability. During downturns, RBI may lower rates to encourage borrowing and spending. On the other hand, the rates may go up to control excessive spending during high inflation.
- Financial market stability: Sudden interest rate fluctuations may impact asset prices and institutions. So, this prompts central banks to provide liquidity or adjust rates. Central banks are responsible for monitoring and intervening in financial markets to maintain stability.
- Exchange rate management: Interest rate differentials impact exchange rates. Central banks regulate the rates to impact their currency’s value, promoting export competitiveness or managing capital flows.
Relationship between interest rates and inflation
Inflation and interest rates are inversely proportional. Lower interest rates may cause people to borrow more from banks and save less. This can lead to an increase in the supply of money in the economy and a rise in demand. Consequently, prices of the commodities may rise and cause inflation.
In this situation, the RBI is likely to increase the interest rates to reduce the money supply. On the other hand, people are likely to borrow less and save more when interest rates are high. This causes a decline in money supply and demand for goods and services and a reduction in price. Here, the central bank may lower the interest rates through its monetary policies aimed to balance the money supply and interest rate, thus creating a conducive environment for economic growth. The monetary policy of RBI refers to the management of interest rates, money supply, and credit availability to enhance growth in the economy.
The RBI manages interest rates using various monetary policy tools:
- Bank rate: It is defined as the interest rate at which the RBI lends to commercial banks. When there is inflation, the RBI increases the rate to reduce the money supply in the system. This is done to ensure commercial banks generate less credit leading to reduced money supply. With less money, demand will become lesser, and prices fall.
- Open Market Operation (OMO): This refers to the purchase and sale of government securities by the RBI. When there is inflation, RBI sells government securities to take out excess liquidity from the market. The buyer of the securities pays in rupee, resulting in less money supply.
- Cash Reserve Ratio (CRR): This refers to the proportion of deposits banks are required to keep with the central bank in cash. If the RBI increases CRR, banks must keep more money that cannot be lent. Consequently, the money supply will reduce causing inflation to come down.
- Statutory Liquidity Ratio (SLR): This refers to the percentage of deposits that banks are required to keep in the form of liquid government securities or other approved securities. An increase in SLR can imply fewer funds to lend and a reduced money supply.
- Repo and reverse repo rates: It is the rate at which RBI lends to banks while the reverse repo rate is the rate at which banks deposit their surplus money to the RBI. Repo and reverse repo rates come under the Liquidity Adjustment Facility tool and are used to control the money supply. A repo rate increase means an increase in borrowing cost, reducing the money supply, and helping control inflation.
- Marginal Standing Facility (MSF): It is a penal rate at which banks borrow from the RBI over and above the LAF. This monetary policy tool enables managing volatility in overnight interest rates in inter-bank lending and there is an indirect impact on the interest rates and money supply in the system.
How does interest rates affect personal finances?
When there is a fall in interest rates, people tend to spend rather than save with low returns. However, when there is a rise in interest rates, savings becomes feasible with higher interest rates on deposits. Thus, people prefer to spend less, leading to increased savings. Hence, higher interest rate is ideal for those looking to save money while it can be disadvantageous for those looking to borrow money, such as home loan.
FAQs
How are inflation and interest rates connected to each other?
Higher inflation can lower the purchasing power of money, resulting in an increase in interest rates as compensation for the increased risk. On the other hand, low inflation may prompt central banks to lower interest rates to promote borrowing and spending.
How does inflation affect interest rates in short term?
In short term, high inflation may lead to higher interest rates, where central banks focus on making borrowing more expensive to control inflation. Low inflation may lead to lower interest rates to boost economic activity.
What is the relationship between inflation and interest rates?
Inflation and interest rates are inversely proportional to each other.
What happens when interest rates rise?
Higher interest rates can make loans more expensive as one has to spend more on interest payments.
Who benefits when interest rates go up?
An increase in interest rates can make loans more expensive, but it benefits banks, insurance companies, brokerage firms, etc.
Who controls interest rates?
Central banks, such as the Reserve Bank of India (RBI), regulate interest rates.
What happens when interest rates go down?
When interest rates go down, it leads to higher spending and lesser savings.
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