Rationale behind raising interest rates

Rationale behind raising interest rates

Source: The Hindu

News: Central banks around the world often raise interest rates to curb inflation.Now, the question arises why central banks raise interest rates.

Rationale behind raising interest rates:

  • Increase in incentives to save and interest: As with the rise in interest rates borrowing cost also increases. So people prefer to invest for better yields.
  • Check inflationary spiral: Due to high interest rates consumption becomes expensive leading to reduction in demands for goods. Finally, the price of goods dropped followed by reduction in wages. In the end the economy witnesses sustained drop in price levels hence forestalling inflationary spiral.
  • Raising rates quickly drains excess liquidity from the market: As burden on the borrowers increase in real terms as real rates also go up with rise in interest rates. 
  • Rise in interest rates led to exponential contraction in the monetary system: In banks, the amount of initial deposit grows multifold due to loans issued against  the deposit as banks operate on the basis of fractional reserve banking system.So,monetary systems contract exponentially when debt is paid off or defaulted. 
  • Correction of asset prices: High interest rates led to lower consumption therefore, a nominal decline in profit. So,stock prices of firms drop.
  • Decrease in inflationary pressures: As new loans become more expensive, and therefore, slow down in new borrowings.
  • Impact future cash flows: Higher interest rates would result in earnings being discounted at higher rates, which would decrease the value of future cash flows compared to a low-interest rate regime.
  • Effects opportunity cost in case of fixed-income securities: With rise in rates the security price corrects to account for the rate increase.
  • Rise in interest rates led to decline in gold prices: Gold moves in comparison with the dollar.Appreciation in the dollar aids depreciation in gold prices. Opportunity cost of holding gold measured in terms of the interest rate received on U.S.Treasury Bills (T-bills). Since, the interest rate of the U.S. T-bills are on the rise. Therefore, there is a decline in gold prices with a rise in rates.

Consequences of RBI’s relentless defence of rupee:

  • Due to artificial elevation of the rupee imports are becoming  artificially cheaper and exports artificially expensive.
  • Domestic producers of developed countries are becoming more competitive due to appreciation of rupee against the pound and Euro.
  • Countries which let their currencies depreciate such as Bangladesh, Vietnam and China enjoy the benefits of being more competitive with their exports. 
  • Negative impact on IT&pharma industries: Defence of the rupee led to price corrections in the IT and pharma industries. 
  • Probability of widening trade deficit as artificially strong rupee means lower sales revenue and profit.
  • Requires greater intervention by the central bank(RBI) to maintain the current exchange rate in case trade deficit widens due to artificially strong rupee. 
  • Rupee may crack due to pressure on domestic exporters and the trade balance: As India has elastic exports and inelastic imports. Exports demand decreases during recessions while demand for imports stays constant during a downturn. 
  • RBI’s relentless defence of rupee led to the decline in gold prices: Gold prices in India fluctuates according to the U.S. dollar and rupee exchange rates. Depreciation of rupee more than gold against the dollar led to increase in the price of gold and vice-versa. But gold prices have declined due RBI’s relentless defense of rupee, and selling U.S. securities to cushion the outflow.

Article: Rationale behind raising interest rates(Anand Srinivasan;Sashwath Swaminathan)

Article Link: https://www.thehindu.com/business/Economy/rationale-behind-raising-interest-rates/article65960316.ece 

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