Reduction in Interest Rates - Imperative for Industrial Growth

Reduction in Interest Rates - Imperative for Industrial Growth

Interest rates are an important monetary tool in the hands of Reserve Bank of India (RBI) to control the money supply in the market and thereby affect inflation, investments, and the economy in general.

RBI, or any Central Bank, generally follows these protocols:

1) If inflation is high, increase the interest rates

Higher interest rates discourage banks to borrow money from the RBI, and these banks in turn increase their interest rates leading to lesser borrowings. This further leads to lower economic growth, decreases the liquidity in the market, and the prices of goods slowly come down thus reducing inflation.

2) If inflation is lower, decrease the interest rates

When the inflation is low, the central bank generally lowers its interest rates. This means that commercial banks borrow more money from the central bank, and they also simultaneously reduce their own lending rates. This further causes an increase in borrowing by the general population who use this money for spending and investing.

When the interest rate is lower, there is less incentive to save and more incentive to spend. This is because saving money doesn't yield big returns like it would have done if interest rates are higher.

Current Scenario

Currently the wholesale inflation is very low (4.38 % in November, 2014) and the RBI is yet to reduce its rates. However, given the current scenario of inflation, it is expected that interest rates will be lowered.

Whenever RBI lowers its interest rates, this provides a positive signal to the businesses and industries, because they are allowed to raise funds and invest money that could lead to more growth.

The task of the central bank lies in balancing the growth in inflation along with making sure that the high interest rates don't dampen industrial growth. For example, as soon as Raghuram Rajan was appointed as the Governor of RBI, he increased the repo rate by 25 basis points (to 7.5 per cent) to control the then inflation in 2013 though it came with some criticism from the industrial sector as well.

Pros & Cons of Lower Interest Rates

Pros:

The Central Bank reduces interest rates when it sees that the inflation is low, and when the market is conducive. The lowering of interest rates sends a positive signal to the industrial sector.

Lowering interest rates also increases the aggregate demand in the market because there's more incentive for spending than there is for saving.

Given the current low rate of inflation if the RBI drops its interest rates, it can provide the necessary momentum for industrial growth.

Lower interest rates are good news for mortgage holders, borrowers, etc.

Cons:

Lowering of interest rate can be termed to be a 'necessary' condition to provide momentum to industrial growth, but by itself it does not form a 'sufficient' condition, because other factors need to be present as well

Lowering interest rates can increase Aggregate Demand, and a prolonged increase in Aggregate Demand can cause a demand-pull inflation

Sometimes it happens that the Central Bank reduces its interest rates but that does not get translated into lower interest rates offered by the commercial banks for consumers. This happened in the recession of 2008 when the Central Banks reduced the rates but the commercial banks did not do so for the consumers.

Lower interest rates isn't a good news for everyone. It is good for industrial growth but for the section that depends on savings, like retired people, they prove to be less profitable. Their savings do not yield higher returns and thus the retired people are left with lower disposable income than before.