An irregular surge in the prices of commodities is given a term called inflation. Why the prices do suddenly starts to rise? Does it happen over night or it’s a slow process which builds up to add up to the inflation? From where does inflation creep in? And how does the inflation affects the interest rate of the economy? Can interest rate affect the rate of inflation?
When our economy starts to grow, manufacturing sectors grows, thus giving rise to the number of job and salaries of the employee’s increases, thus increasing disposable income in the pockets of the individuals. Disposable income, is the in hand cash of the individual, which they can spend on themselves.
What do we do when we have ample cash in hand? We spend and spend, thus increasing demand in the market. As the demand rises in retail market, the wind of rising demand reaches to wholesaler and then to the manufacturer. Now the manufacturer knows that masses have money and they wish to spend it, thus it’s the time to reap the profit. So he increases the prices of the products, which follows the chain. Manufacturer increases thus wholesaler and then retailer, now buyer’s starts to feel the heat on inflation. As the individuals has to shed more money to buy a smaller quantity of product.
Now comes the second stage, as the prices starts to rise abnormally, and masses feels the heat and affordability in the market goes down. Various classes of society has to degrade their standard of living, thus to stop this abrupt rise in price and maintain the economic balance.
Bank has to poke its nose in the ongoing economic scenario, to get back to the balance. Central bank comes in action to control the level of prices.
Central Bank has two ways to control inflation one is open market operation and other one being controlling the key rates.
Open market operation, famously known as OMO, is used to control the circulation of money in the market, by buying and selling government securities.
The case we are discussing here is inflation, which somewhere down the lines indicates higher flow of cash in the system. So to control inflation, Central bank needs to implicate in excess money present in the system. In order to get the desire result, RBI sells government securities to the bank, thus banks end up with lesser cash to lend loans and thus banks increases rate of interest for lending money, because they have less cash to lend loan but to maintain their income level, bank increase the rate of interest, so the cost of buying money increases. This leads manufacturer to reduce its activity, thus slowing down on no. of jobs and increase in salary, thus ultimately reducing the disposable income in the hand of masses. Further personal loans also become expensive, it puts axe on the demand. A slowdown in demand thus put pressure on the suppliers to lower the prices, thus prices come under control.
The other option, which central bank has is increasing the major interest rate like CRR ratio, SLR and REPO rate.
CRR: Cash Reserve Ratio
which is currently maintained at the level of 4% , is the percentage of net demand and time liabilities , which has to be mandatory maintained in cash with the bank at the end of every single day.
SLR: Statutory Liquidity Ratio
which currently stands at the rate of 19.5%, is the rate determined by RBI, to be maintained by the banks in the form of cash or government securities, which can be easily converted into cash.
When RBI increases the rate of both CRR and SLR to manage the liquidity of the market, it main aim is to catch up in the excess liquidity from the economy. The same process then happened as explained in the section of open market operation.
Thus, interest rate and inflation are tied with same thread, if one is stretched the other follows.
Nisha Sharma is a research analyst with a passion for writing on emerging terminologies in the areas of stock market trading and investing. She has 7+ years of experience in share market, currently associated with advisorymandi.com. It`s give unique platform for advisors and traders, which provides pragmatic and unfathomable research and advisory in the stock market.