Relation between Inflation and Bank interest Rates
Now a days, you might have heard lot of these terms and usage on inflation and the bank interest rates. We are trying to make it simple for you to understand the relation between inflation and bank interest rates in India. (What is Deflation?)
Bank interest rate depends on many other factors, out of that the major one is inflation. Whenever you see an increase on inflation, there will be an increase of interest rate also.
What is Inflation?
Inflation is defined as an increase in the price of bunch of Goods and services that projects the Indian economy. An increase in inflation figures occurs when there is an increase in the average level of prices in Goods and services. Inflation happens when there are less Goods and more buyers, this will result in increase in the price of Goods, since there is more demand and less supply of the goods.
Inflation causes increase of Interest
Inflation can be recognized as a combination of 4 factors :
- The Supply of money goes up
- The Supply of Goods goes down
- Demand for money goes down
- Demand for goods goes up
Our Indian government gets involved in it to control the inflation by adjusting the level of money in our economical system. The most noticeable way to increase the money flow in the system is to print more currency, then the rupees will become more relative to goods.
Inflation and Global Liquidity
Factors like rates of import and export, the production cost of farms, value of dollar, price of oil (crude oil), market movements of other overseas markets cause global liquidity. In India, we can also feel the effects of global liquidity. We are not isolated from all these issues now. Due to the remarkable economic growth of India over the recent years, increase in foreign currency inflow caused the demand in multiples for many Merchandise and services in India. RBI (Reserve Bank of India) needs to control this excess liquidity in our economic system. For this, RBI increases the Repo rates which makes Costly Credits and thus increases the CRR rate (Cash Reserve Ratio). This kind of measures by RBI can only control the inflation to a certain extent only.
Due to Globalisation, no country are independent from Global Liquidities. This causes an important factor for the inflation in a country. A political crunch or economical downturn in a far away country can impact our money value in India
What is a CRR rate?
Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.
What is a Bank Rate?
Bank rate is the rate at which RBI gives to the commercial banks. Whenever RBI increases its rates, the effect will be shown on the commercial banks. In this case, the commercial banks have to increase the interest rates for their profits.
What is a Repo Rate?
Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive.
What is a Reverse Repo Rate?
Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from banks. Banks are always happy to lend money to RBI since their money are 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 this attractive interest rates. It can cause the money to be drawn out of the banking system.
Due to this fine tuning of RBI using its tools of CRR, Bank Rate, Repo Rate and Reverse Repo rate our banks adjust their lending or investment rates for common man.
Recommended Read :
- What is Inflation?
- What is Inflation Risk?
- What is Deflation?
- What is Interest Rate?
- What is Fixed Rate of Interest?
- What is Floating Rate of Interest?
- Effects of Interest Rate Fluctuations
- Who controls Interest Rates?
- Who sets Fixed Deposit interest rate?
- What is Interest Rate Risk?
- How Interest Rates affect Real Estate Business?
- What is Compound Interest?
- Prime Lending Rate PLR
- What is Interest Income?
- What is Interest Rate After Tax?