An article that I have written as a B3 guy...go through it...might help!...
When I was a kid, I used to go to the market with my mother. I remember watching her purchase a kilo of potatoes at Rs. 2.50 a kg. Sometimes, she would treat me to golguppe at the laneside hawker who would generously give 6 pieces for a mere Rs. 1.50. An auto rickshaw ride back to home after I got tired would cost us Rs. 2. Bombay was so much cheaper those days. The whole chore would be completed in Rs. 6. But now when she gives me the same errand (& I indulge myself to the golguppe from the same hawker), it takes me Rs. 30 to fulfill them! Rs. 12 for the same 1 kg of potatoes, Rs. 10 for the same auto ride, and Rs. 8 for the same serving of golguppe. Mumbai does differ from Bombay in a lot of ways other than their spellings!
This is the direct effect of inflation. When the purchasing power a rupee dwindles with time, the trend is called 'inflation'. This is manifested in a general rise in prices of goods and services. With most of India’s vast population living close to – or below – the poverty line, inflation acts as a ‘Poor Man’s Tax’ in our country.
India is facing the problem of inflationary pressure because Aggregate Demand (AD) is increasing while Aggregate Supply (AS) is more or less constant. Thus, to curb inflation, the gap between AD and AS needs to be minimized. Increasing AS with an immediate effect is next to impossible as all resources are fully employed and tapping the alternatives or building newer production plants would take quite some time which cannot commensurate with the pace at which Indian economy is developing.
The most direct way to reduce AD is to increase interest rates. This is a form of “artificial suppression” of inflation. This would reduce both consumption and investment. In the 70s, there was a minor debate whether to increase interest rates or reduce the money supply directly from the mint, but that debate died long ago once central bankers found out that in practice, tinkering with money supply led to far more uncertainty (about policy outcomes) than tinkering with interest rates.
Repo rate is the difference between the purchase price and reselling price of a security, expressed as a percentage. If commercial banks are short of money, they enter into an agreement with the RBI to sell their securities for a short term (overnight or fortnight) and then repurchase these securities at a slightly higher price. If the repo rate for commercial banks increases they will pass this onto their consumers. If the bank is paying a higher rate of interest to borrow money, we are the one who will bear the cost — we will have to shell out a higher rate of interest when we pay off the loan. Higher interest rates have the effect of reducing expenditures and investments of the populace. This will reduce inflationary strains in the economy.
Reverse Repo rate is the interest rate at which the RBI borrows money from banks. Banks are always happy to lend money to RBI since their money is in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to the attractive interest rate that they earn later during reimbursement. Thus, it can cause the money to be drawn out of the banking system, & hence from the economy in the short run, curtailing liquidity temporarily.
Let’s understand all of the above by way of an illustration. Suppose you need money for some reason and you apply for a loan. The bank you approach may have already exhausted all its available money by:
1. Loaning to other borrowers
2. The mandatory cash reserve with RBI
3. Transfer of funds to the RBI by reverse repo.
This does not mean it will refuse your loan request. The bank will approach the RBI for money. The RBI lends this money to the bank at a fixed rate of interest (the repo rate fixed during the credit policy; the credit policy is announced every quarter.) Now, the RBI decides to pull up the repo rate in one of its credit policy. The bank will simply reflect this in the loans it offers to us by shooting up the interest rates proportionately. This will slow down the transaction activities of loans. Not many would come up for loans thus eliminating excess liquidity from the root. Inflation will tend to cease in the face of such a “credit crunch”.
In a nutshell,
Higher CRR, higher repo rate and higher reverse repo rate -> Bank’s ability of lending goes down -> Contraction of money supply into the economy -> Lesser liquidity -> Lesser money (cash) and hence lesser demand to buy goods and services -> Lower inflation.
According to the 2008 Economic Survey Report, India’s inflation rate was targeted by the RBI to be 4.1% with an upper limit of 5%, down from a rate of 5.77% in 2007. However, the beginning of 2008 has seen a dramatic rise in the prices of basic food stuffs, oil, gas and majority of the commodities leading to higher inflation. Indeed, by July 2008, the Wholesale Price Index (WPI), the key indicator of the rate of inflation in Indian economy, had risen touching 12%. In early August, the inflation rate was 12.63%, the highest in 13 years. It had jumped into double digits after a hike in retail fuel rates in June. This is more than 6% higher than a year earlier and three times the RBI’s target of 4.1%! (The WPI was more closely watched than the consumer price index (CPI) because it includes more products and is also published weekly. The CPI is released monthly).
