In our previous article, we discussed the various components of Monetary Policy and how monetary policy affects the interest rates across the banking and financial system of the country.
In this article, we would discuss the impact of changes in interest rates or monetary policy on various indicators of the economy.
If you have not gone through the previous article,
Impact of increase in interest rates:
Impact on Companies
An increase in interest rates increases the borrowing cost of companies. i.e. if the companies would take loans, they would be required to pay high interest.
An increase in borrowing costs would increase the cost of capital of companies.
When the borrowing cost increases the companies try to cut down on investment expenditures because the loan has now become costlier and therefore, the companies would be less intended to take loans to finance their capital expenditures.
Impact on Households
Due to an increase in interest rates, households may postpone their decisions of purchasing homes, cars, and other goods of durability that are available on finance.
Due to the reduction of purchases (.i.e. reduction of demand) by households and reduced capital expenditure by companies, the businesses would reduce production and if the production gets reduced, employment would also be reduced.
Impact on the Stock Markets
When interest rates are increased in monetary policy, the money outflow would start from stock markets.
Since the stock markets are risky and with the increase in interest rates the investors would be more attracted towards debt instruments and fixed deposits.
With the increase in interest rates, the returns on fixed deposits and debt instruments (.i.e. bonds) would increase, therefore investors try to pull their money from Stock Markets and keep it in fixed deposits or debt.
Impact on Inflation
As the interest rates are increased in monetary policy, the loans would become costly in the entire banking system.
Due to the costlier loans, the demand decreases which in turn leads to the controlling of inflation.
Impact of decrease in interest rates:
Impact on Companies
A decrease in interest rates decreases the borrowing cost of companies. i.e. if the companies would take loans, they would be required to pay low interest.
A decrease in borrowing costs would decrease the cost of capital of companies.
When the borrowing cost decreases the companies try to expand the investment expenditures because the loan has now become cheaper and therefore, the companies would be more intended to take loans to finance their capital expenditures.
Generally, the reduction in interest rates is done in times of economic drawdowns when it becomes necessary to boost the economy.
You may have seen the same during the time of Covid-19.
Impact on Households
Due to a decrease in interest rates, households may try to expand on their decisions to purchase homes, cars, and other goods of durability that are available on finance.
Due to the increment of purchases (.i.e. increment of demand) by households and increased capital expenditure by companies, the businesses would increase production and if the production gets increased, the employment would also be increased.
Impact on the Stock Markets
When interest rates are decreased in monetary policy, the money inflow would start in stock markets.
Since the interest rates are reduced, the investors would get less return on fixed deposits and debt instruments.
The stock markets are risky but the return on fixed deposits and debt instruments would be unable to attract investments due to low returns because of reduced interest rates.
Therefore, they would shift their focus toward stock markets as you have seen during the times of Covid-19.
During the time of Covid-19, there was an exponential increase in the stock market investors and traders.
The stock market is a discounting machine.
Stock Markets try to predict the stance of RBI towards interest rates and discount the monetary policy outcomes immediately.
Due to this reason, you may have seen corrections and upward movements in the stock markets during the times of the announcement of monetary policy.
Inflation
Inflation depends mainly on two factors:
1. Demand
2. Cost
On the basis of demand and cost, inflation is of two types:
- Demand-Pull Inflation and 2. Cost-Push Inflation
Demand-Pull Inflation
Inflation that is created due to an increase in demand is called demand-pull inflation.
When the flow of money in the economy is high it leads to an increase in demand, on the other hand, production takes time to increase. i.e. production cannot be increased immediately.
When the increase in demand is more than the increment in production the prices of goods increases.
This increment in prices is due to an increase in demand and therefore it is called demand-pull inflation.
Cost-Push Inflation
Inflation which is created due to an increase in the cost of production is called cost-push inflation.
The increase in the cost of production can be due to an increase in the price of raw materials (like an increase in oil prices, increase in labour wages, natural disasters, and wars as recently between Russia and Ukraine) by which the final product is produced.
When the cost of production increases the companies have no option other than to increase the prices otherwise the profits of the companies would be affected.
So inflation comes into existence due to the increase in the cost of production. Such inflation is called cost-push inflation.
Impact of interest rates on currency exchange rates
In today’s globalised economic environment, the citizens and financial institutions of a country are making investments in other countries.
The Indian people are doing investments in the United States (US), and the US people and institutions are also doing investments in India.
Let’s say, institutions from the US want to invest in India for this they have to buy an Indian rupee in exchange for the US dollar because, in India, investments in any asset can be done in rupee only.
Assume that the present exchange rate is 1$ = Rs.75.
When they buy the rupee for investment in India, the demand for the Indian rupee would increase and therefore the exchange rate would become 1$ = Rs.76 (.i.e. Rupee appreciated).
The most important factors that attract foreign money are the economical and political stability of the country because everybody wants to invest in stable countries rather than unstable ones, so as to ensure the safety of their investments.
Investment in other countries has its own risks in the form of exchange rates, the possibility of changes in economic conditions, the possibility of changes in government policies, rules and regulations, etc.
Now, if the US Federal Reserve increases the interest rates, the US citizen would now get more returns on his investments, and that too risk-free.
So if the US citizens are able to get good returns in their own home country then why would they invest in other countries?
The answer is “They would not invest in other countries”.
Understand this by an example, let’s say you have Rs 10 lakhs and you want to invest them in a fixed deposit.
If a bank in your colony is giving a 7.5% rate of interest and a bank in some other city is offering a 10% interest rate, then where would you invest?
The answer is obvious you would choose the bank in another city because the difference in rates of interest is 2.5%.
But you have the risk that the bank is far away, you would need more time to deal with the bank staff, staff might be unknown to you, in case of any problem you might need to travel a long way, etc.
In spite of the above-mentioned reasons, you would invest in the other city because the difference in interest rate is much higher. i.e. 2.5%.
Now let’s say the bank in your colony increases the rate of interest to 9.5% now, what would you do?
Obviously, you would transfer your fixed deposit to the bank in your colony as it would not be great for you to take all the above risks just for a 0.5% difference in rates of interest.
It would be much easier for you to deal with the bank staff because you might be familiar with them, your traveling time would reduce, etc.
The same is the case with the US investor if US Fed increases the rate of interest the money would flow out of India to the US.
So it can be said that if the central bank increases the rate of interest, the local currency appreciates (For US investors $ is the local currency).
They would sell their investments in India and move their money to the US.
When they move their money to the US they would need US Dollars and therefore they would convert their rupee into US dollars which would increase the demand for US dollars and now the exchange rate which was 1$ = 76 Rs would become 1$ = 74 Rs . i.e. anything lower than 1$ = Rs.76, meaning thereby the USD would appreciate.
Impact of Exchange rates on Exports (In the manufacturing sector)
If the domestic currency (Indian Rupee) appreciates
The appreciation of domestic currency makes domestically-produced goods more expensive in comparison to foreign-produced goods.
Let’s say Rs.75 = 1$ is the present exchange rate between the rupee and the dollar.
Now if an American wants to purchase a product costing Rs.150 from India he would need 2$ because 1$ is equal to Rs.75, therefore Rs.150 means 2 dollars.
If the exchange rate becomes 1$ = Rs.70 .i.e. rupee appreciated.
Now the same American would require more than two dollars to purchase the same product from India.
It might be possible, the same American would not buy the product from India because it has now become costly (Previously he was required to pay 2$ and now after rupee appreciation, he would have to pay more than 2$).
If the foreigners do not buy Indian products then our exports would reduce which in turn would lead to the fall of production in India.
Why the companies in India would produce if they are not able to export?
If the production is reduced. i.e. output is reduced, the companies would employ fewer persons meaning thereby, the employment would fall.
So if the domestic currency appreciates the export falls the production falls and employment also gets reduced.
If the domestic currency (Indian Rupee) depreciates
The depreciation of domestic currency makes domestically produced goods cheaper.
Let’s say Rs.75 = 1$ is the present exchange rate between the rupee and the dollar.
Now if an American wants to purchase a product costing Rs.150 from India he would need 2$ because 1$ is equal to Rs.75, therefore Rs.150 means 2 dollars.
If the exchange rate becomes 1$ = Rs.80 .i.e. rupee depreciated.
Now the same American would require less than two dollars to purchase the same product from India.
It might be possible, the same American would buy the product from India because it has now become cheaper for him (Previously he was required to pay 2$ and now after rupee depreciation, he would have to pay less than 2$).
If foreigners buy Indian products then our exports would increase which in turn would lead to an increase in production in India.
To increase production, the companies would employ more persons meaning thereby, employment would also increase.
So if the domestic currency depreciates the export would also increases and employment would also be generated.
Impact of Exchange rates on Exports (In the service sector)
If the domestic currency (Indian Rupee) depreciates, it is beneficial for service exports.
Let us understand this by an example if you are an exporter of services from India.
let’s say, The present exchange rate is 1$ = Rs.70. If you are providing service to the US and raised a bill of $ 1000, you would receive $ 1000.
When you convert this dollar into rupees you would get Rs.70,000.
Now let’s say the exchange rate becomes 1$ = Rs.75.
Now if you raise the same bill of US dollar 1000 then you would get Rs.75,000.
So if the domestic currency depreciates, the exporters try to export more and more because they would get more rupees for the same set of services given by them.
Therefore we can say that depreciation of domestic currency increases exports.
Impact of exchange rates on imports
If the domestic currency (Indian Rupee) appreciates
If domestic currency appreciates, it would be beneficial to import goods but only in monetary terms.
Let’s say, if 1$ = Rs.75 and you are importing a product of 2$ then you would have to pay Rs.150 to make a payment of two dollars.
But if 1$ = Rs.70 you need to pay Rs.140 for making a payment of the same 2 US dollar product.
So it would be beneficial by Rs.10 but only in monetary terms.
For the economy as a whole, the increase in imports is not considered healthy.
If the imports are increased domestic production would fall. This would lead to a reduction in employment because the business would now try to import rather than produce by themselves.
Secondly, when we import from outside India we need to pay in foreign currency. So an increase in imports would lead to a reduction in foreign currency reserves held by our country.
If the domestic currency (Indian Rupee) depreciates
If the domestic currency depreciates, it would not be beneficial for the imports.
Let’s say if 1$ = Rs.75 and you are importing a product of 2 US dollars. You would need to pay Rs.150 to make a payment of 2 US dollars.
But if 1 US dollar becomes equal to 80 Rs . i.e. domestic currency depreciates.
Now if you need to pay for a two-dollar product then you would need Rs.160 to make the payment so you would end up making a loss of Rs.10 on the same product of two US dollars.
Therefore if the domestic currency depreciates the imports would get reduced and the domestic production increases because the companies would try to produce the products by themselves rather than relying on imports.
If domestic production would increase, employment would increase and we would save our precious foreign currency reserves from drying out.
So depreciation of the domestic currency is also good for the economy but that should be up to a limit as per the macroeconomic needs of the country.
We have tried our level best to give you a basic understanding of monetary policy and the impact of interest rate fluctuations on the various components of economy. There are a lot of other factors on which the stable economy of a country depends, we would try to discuss them as and when necessary.
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