Inflation Management: Divide Interest Rate and Rule Inflation
Olympics 2008 was the headline grabber for nearly a month. But a recurring weekly headline these days is the soaring inflation levels in many economies. And it seems like ‘north’ is the only direction that inflation would like to walk around in the near future.
Central Bank and the Government take monetary and fiscal measures respectively, in an attempt to maintain a comfortable inflation level. When the present economies are struggling to contain inflation, the idea proposed in this blog might bring down inflation to a certain level; after which the normal routine of control measures can be continued.
The fact that inflation hardens interest rates is well known. But can an economy tame inflation by having disparate interest rate policies for corporate and retail borrowers? This blog describes the merits, demerits and feasibility of this idea at a very high level without delving into numbers.
Let us assume an interest rate regime, where the central bank can tweak the lending rates for corporate and retail borrowers separately. This helps in the current context, where the focus is on reducing consumption levels to fight inflation.
1. By the law of inverse variation, consumption levels can be decreased by increasing the interest rates to borrowers. The increase in the cost of borrowing reduces the aggregate demand in the economy, forcing the suppliers to reduce prices.
2. By the law of direct variation, a softer interest rate to the supplier will encourage investments in production. The increased volume of output will drive the prices further down.
How to use this tool? Fiddling with the interest rate should be done only to bring the economic situation under control. This should be a short term approach after which the central bank should revert to its own earlier practices of inflation management.
When to use? This works only in situations where price levels can be reduced by reducing the consumption quantity.
Merits
A quick and short term solution can be arrived at.
Demerits
1. Consumers fail to understand the long term benefits as there are more bad news in the short run. The poor who need more money during high inflation will be more worried with increase in borrowing rates.
2. The Government might be misconstrued as adopting Capitalist ideals by favouring companies over consumers.
3. The banks prefer lending to retail borrowers as against companies as the returns are higher.
4. How much of consumption will be reduced because of increase in interest rate is vague.
Olympics 2008 was the headline grabber for nearly a month. But a recurring weekly headline these days is the soaring inflation levels in many economies. And it seems like ‘north’ is the only direction that inflation would like to walk around in the near future.
Central Bank and the Government take monetary and fiscal measures respectively, in an attempt to maintain a comfortable inflation level. When the present economies are struggling to contain inflation, the idea proposed in this blog might bring down inflation to a certain level; after which the normal routine of control measures can be continued.
The fact that inflation hardens interest rates is well known. But can an economy tame inflation by having disparate interest rate policies for corporate and retail borrowers? This blog describes the merits, demerits and feasibility of this idea at a very high level without delving into numbers.
Let us assume an interest rate regime, where the central bank can tweak the lending rates for corporate and retail borrowers separately. This helps in the current context, where the focus is on reducing consumption levels to fight inflation.
1. By the law of inverse variation, consumption levels can be decreased by increasing the interest rates to borrowers. The increase in the cost of borrowing reduces the aggregate demand in the economy, forcing the suppliers to reduce prices.
2. By the law of direct variation, a softer interest rate to the supplier will encourage investments in production. The increased volume of output will drive the prices further down.
How to use this tool? Fiddling with the interest rate should be done only to bring the economic situation under control. This should be a short term approach after which the central bank should revert to its own earlier practices of inflation management.
When to use? This works only in situations where price levels can be reduced by reducing the consumption quantity.
Merits
A quick and short term solution can be arrived at.
Demerits
1. Consumers fail to understand the long term benefits as there are more bad news in the short run. The poor who need more money during high inflation will be more worried with increase in borrowing rates.
2. The Government might be misconstrued as adopting Capitalist ideals by favouring companies over consumers.
3. The banks prefer lending to retail borrowers as against companies as the returns are higher.
4. How much of consumption will be reduced because of increase in interest rate is vague.
5. The problem of Moral Hazard will become unavoidable. People needing money for personal reasons might convince the bank to lend for their fictitious businesses. This level of micro-management for banks is a headache.
Feasibility
This idea will help only when the merits outweigh the demerits and all stakeholders arrive at a consensus. The economic system should be compatible as the risks involved are more.
However, on the face of it, the sounds like "plugging one hole is opening up many bigger holes at the wrong places"
If you think this article is weird, how can a B-school student write any better? We are a different tribe!
For proof: http://in.youtube.com/watch?v=8Vx1BTBhg4c
For management quizzers, there’s more from this blog. Check the quiz section for interesting questions.
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Bye. Catch you in the next post.
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