In the early August meeting the MPC of RBI decided to keep interest rates unchanged. Some expected the RBI to cut the repo rate (the interest rate that the RBI charges Banks borrow from it) as growth was falling and going negative. Due to Covid-19 disruption many predictors expect the economy to contract by as much as 10 per cent in the current financial year. Other expect that repo rate will be increased or maintained to control inflation (>6%). Finally, after three days of discussion, RBI’s MPC unanimously chose to maintain the status quo on the repo rate.
In a growing economy, incomes go up and people have more money to spend, meaning more money chasing same number of goods, as supply is unaffected initially. This increased demand for goods increases their prices, which is inflation. Reducing money available and spent by public can control inflation. Increasing interest rates causes people to save rather than spend, thus reducing money available in the market and hence leading to reduced demand. This prevents increase in prices.
When growth contracts, then people’s incomes also get hit, resulting in less and less money is chasing the same quantity of goods. This results in either the inflation rate decelerating or it actually contracting. In such situations, reduction in interests rate reduces desire to save and people spend more in the market, which boost economics activity. As more and more money comes into the market, growth and inflation get boosted.
Presently, GDP of the country is contracting due to the covid19 pandemic even while inflation is higher than 6%, the limit within which MPC of RBI is mandated to keep inflation within. This is happening because the pandemic has reduced demand, on the one hand, and disrupted supply on the other. As a result, we see falling growth and rising inflation. It is necessary to raise interest rate at this stage to cap inflation, which would however have a deleterious effect on India’s GDP growth.
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