India Cuts Interest Rates for Third Time This Year - Essay Example

? Macro & Micro economics Table of Contents 0 Article Summary 3 2.0 Introduction 3 3.0 Analysis 4 3 Monetary policy 4 3.2 Fiscal Policy 6 3.3 Structural growth in the economy 7 4.0 Conclusion 8 References 10 1.0 Article Summary The article by the title “India cuts interest rates for third time this year” has been published online in the BBC News on 3rd May 2013. The report says that the Reserve Bank of India (RBI) has reduced interest rates in the country from 7.50 percent to 7.25 percent with the aim of introducing fresh waves of economic growth in the economy in the face of sluggish economic growth. It is also reported that the RBI cannot freely embark on such expansionary measure since inflation rate in the country is not at a safely low standard. Structural constraints faced by the economy have also been highlighted in the economy. 2.0 Introduction The GDP growth in India has been below potential in the last financial year (2012). Real GDP in the country has grown at the rate of 6.5 percent (according to 2012 estimate) (CIA, 2013). In 2011, the rate has been 6.8 percent (CIA, 2013). Hence there has been a 0.2 percent fall in the real GDP growth. According to a report from a leading newspaper of the country, the manufacturing sector is the major factor that is pulling the country’s growth rate downwards. This sector accounts for almost 17 percent of the country’s GDP. In the third quarter of the last year, the manufacturing sector grew by a meagre 0.8 percent. While India is mainly an agrarian economy, agriculture has grown at the rate of 1.2 percent in this quarter. This is definitely a gloomy picture that suggests that the government has a role to play to push the country’s growth status. The government of India has taken expansionary monetary policy to spur economic activities in the country. 3.0 Analysis 3.1 Monetary policy In the last year (2012) the government of India had increased interest rates to control inflationary pressure since rates of consumer price inflation fluctuated around 7.5 percent in the first two quarters of 2012 (Trading Economics, 2012). However, this policy failed to reduce inflation rates to the desirable extent. The most undesirable side effect has been felt on the level of private investment activities; fresh investment (as measured by the Gross fixed capital formation (GFCF)) was found to be only 33 percent of the GDP (Choudhury, 2012). GDP forecast for FY2013-14 has been scaled down from 6.2 percent to 6 percent by international brokerage firm Barclays (Economic Times, 2013a). The government has therefore taken expansionary fiscal policy to boost up investment activities in the country. The reserve bank of India has cut interest rates by 0.25 percent in May 2013, thereby reducing the repo rate from 7.5 percent to 7.25 percent (BBC, 2013). India is the third largest country in Asia and the government has cut interest rates in order to “stimulate a fresh wave of economic growth” (BBC, 2013). This policy has been adopted in an endeavour to swell money supply in the economy. Thus banks would possess more money for lending out to borrowers (NASDAQ, 2011). Rate of interest “is the opportunity cost of holding money” (Boyes and Melvin, 2008, 339). Low interest rate can be interpreted in this way; there is little opportunity cost of holding money. Money demand has negative relationship with rate of interest (Walsh, 2003). Therefore the money demand curve has a downward slope. As interest rate shrinks quantity of money demand rises. It is illustrated by the following figure: Figure: Money demand is a negative function of rate of interest (Source: Author’s Creation) As interest rates are reduced, supply of loanable funds increase. This increases investment and consumption activities in the country. Figure: Lowering of interest rate supply of loanable funds rise (Source: Author’s Creation) Higher availability of lendable funds reduces interest rates from i1 to 12 and quantity of money demanded rises from L1 to L2. Downward trend of inflation in mid 2013 The inflation rate has been showing a downward trend since April 2013. After a rate of 7.28 percent inflation rate in March 2013, the rate has fallen to 5.96 percent in April and further to 4.89 percent in May (Trading Economics, 2012). Figure: Graph demonstrating inflation rate over two years period (Source: Trading Economics, 2012) This is a record low after a span of forty-one months (Economic Times, 2013b). The interest rate has dropped to expected comfort region of the central bank, i.e., “less than 5 per cent” (Economic Times, 2013b). This is a new emergence that is fuelling hopes of greater prospects of adopting monetary easing policies by the Reserve bank of India. This would be beneficial for the economy as it would revive economic growth in the country. According to estimates by Barclays, the repo rate is expected to be reduced by another 0.25 percent which would bring the rate to 7 percent (Economic Times, 2013b). If the inflation rate shows such declining trend over these present months, the possibility of cuts in the interest rate by the RBI in the middle of this year rises significantly. However, the Chief Economist of HSBC Bank for India & ASEAN, Leif Lybecker Eskesen, has warned that despite the current favourable picture of the inflation situation in India, one has to consider the big deficit in the current account in the country. Before making long range plans to bring growth the government has to identify the structural constraints and cure them that pose strong hurdles to growth in any developing country. 3.2 Fiscal Policy As a measure towards economic restructuring, the Finance Minister of the country, P. Chidambaram, has expressed his desire to focus on raising revenue rather than cutting government expenditure. This policy supports the current requirement of the country; to make reforms that would cure the structural constraints faced by the country. With expenditures maintained at the level as before, the government would be able to ensure that the infrastructural developments occur undisturbed in the country. Total expenditure by the government as a percentage of GDP of the country has been set to rise by 16 percent for the financial year 2013-2014 (Kumar and Singh, 2013). This would boost up private investors and allow them to make more investment ventures. Government finances would be shored up by way of imposing higher tax rates on the large business houses and the rich class. This revenue is to be expended on the social sector and developing the rural areas (Kumar and Singh, 2013). 3.3 Structural growth in the economy The Reserve Bank of India is not confident enough to adopt the route of easy monetary policy. Aggressive accommodative policy poses the risk of inflationary pressures. If interest rates are cut to a significant extent the immediate effect would be felt in the ability of the borrowers to make huge amount of borrowings. They would have more disposable income, which implies that spending by consumers would rise. Although the interest rate cut is made with the objective of boosting private investment, changes in supply stock cannot be brought in the very short term. However, changes in consumer demand can be felt immediately after the cut in interest rates. Hence it gives rise to risks of inflation. Production of goods and services in the economy can be increased by addressing “the structural constraints” (BBC, 2013) in the economy. This concern has been addressed by Radhika Rao, DBS bank Economist. According to her, it would be safe for the central bank to “embark on an aggressive easing cycle” (BBC, 2013) only after making sure that the country is structurally advanced so as to keep pace with the increment in consumption demand. Otherwise, it might lead to “resurgence of inflation pressures” (BBC, 2013) owing to demand pull inflation as illustrated in the figure below: Figure: Demand Pull inflation (Source: Author’s Creation) The aggregate demand rises in the short run from AD1 to AD2. The potential GDP for the economy is denoted by the point A. but due to increased demand it moves to point B, and the corresponding price moves up to P2 from P1. Structural development can be made by improving production in the country through establishment of new plants and modern infrastructure. The aim of such efforts would be towards increasing productivity and pull up employment levels. The cut in interest rates is purposefully made to increase the growth rate of the economy. In this context the best measure way for the government to spur development is by creating more jobs in the economy which would also increase production levels in the country (UN, 2013). 4.0 Conclusion The Indian economy has been depicting sluggish growth since 2012. Low economic output is paired with high inflation. This has made the government take active participation in the economic affairs of the country via monetary and fiscal policies. The RBI has adopted expansionary monetary policy through cuts in the interest rate with the aim of increasing private investments in the country. It would also boost up the consumers by increasing their disposable income since there would be greater availability of loanable funds in the economy. However, economists are concerned about the risk of high inflationary pressure that might result from the low interest rate due to greater supply of money in the economy. In order to enhance growth in the country, the government has to remove the structural constraints in the economy and generate greater employment opportunities in the country. References BBC. 2013. India cuts interest rates for third time this year. Accessed 25 May, 2013, http://www.bbc.co.uk/news/business-22394212 Boyes, William J. and Michael Melvin. 2008. Fundamentals of Economics. Connecticut: Cengage Learning. Choudhury, Gaurav. 2012. How slow GDP growth affects you. Accessed 25 May, 2013, http://www.hindustantimes.com/business-news/WorldEconomy/How-slow-GDP-growth-affects-you/Article1-968388.aspx Economic Times. 2013a. Barclays lowers India growth forecast to 6 pc for FY14. Accessed 25 May, 2013, http://articles.economictimes.indiatimes.com/2013-05-21/news/39418636_1_growth-forecast-barclays-capital-cent-y-y Economic Times. 2013b. RBI likely to cut policy rates at its June 17 meeting: Experts. Accessed 25 May, 2013, http://economictimes.indiatimes.com/news/economy/policy/rbi-likely-to-cut-policy-rates-at-its-june-17-meeting-experts/articleshow/20132105.cms Kumar, Manoj and Rajesh Kumar Singh. 2013. Budget 2013: Chidambaram increases spending, taxes the rich. Accessed 25 May, 2013, http://in.reuters.com/article/2013/02/28/india-union-budget-2013-growth-idINDEE91R03G20130228 Trading Economics. 2012. India inflation rate. Accessed 25 May, 2013, http://www.tradingeconomics.com/india/inflation-cpi UN. 2013. Global economic growth still sluggish, with prospect of gradual improvement – UN report. Accessed 25 May, 2013, http://www.un.org/apps/news/story.asp?NewsID=44977&Cr=global+economy&Cr1=#.UaBm4aI3D4Q Walsh, Carl E. 2003. Monetary Theory and Policy. Massachusetts: MIT Press. Read More