Case on importance of interest rates in banking sector and overall economy

As Professor Prashant Gupta entered the class, he found a heavy silence. Whats the matter of the class? Friday blues? the professor asked in a jovial tone. Mehak, a student, seemed as usual perplexed and showed the Professor an article on interest rates, I cannot figure out the fuss about interest rates and monetary policy ,he said. Professor Gupta looked at the article in the usual manner; a frown on his face leading to a grin at the end of the article. He rolled up his sleeves and said,Ok , lets start with the basics. What are interest rates? Interest rates are simply the cost of the money. Just like we need to pay a price for buying a burger at Mc Donalds or movie tickets ,we need to pay a price for borrowing money .That is what we call cost of funds from the point of view of the borrower and for the person lending ,it is the price received, which we called yield on capital. Another boy sitting at the back, suddenly, as if he had found what he has been looking for read out aloud, despite the implementation of reforms, structural rigidities remained in interest rate structure distorting the true market-determined rates .Rates had been kept artificially high by offering highadministered rates on small savings and provident funds. The gap between the short term and long term rates tended to remain high on account of this. The Professor nodded his head. You are right. But we should be aware of the linkage between interest rates, its role in the banking system and other asset prices.Sanjay(the topper of the class),who was listening silently till now, remarked, But interest rates in developing countries like India and Brazil continue to be very high relative to the rates prevailing in global market. Cant disagree with you Sanjay, I get what you are leading at,the Professor remarked. Mehak was a little dumb-founded, Will you care to clarify?.Sanjay explained, Against the backdrop of a slowing Indian economy, bank rates and administered rates on small savings were cut in 1990s.Added to this ,The RBI proclaimed the policy of pursuing a lower interest rate regime. However the recent hike in interest rates shows that the rate would go up and down depending upon the market requirements. It was then that another student Akriti decided to enter the discussion, But sir what does RBI has to do with interest rates? Why cant they let interest rates move on their own? Professor Gupta further explained Industrial growth is a pre-requisite for economic development. Every industry requires finance for establishment, expansion and working capital management. Bank credit is considered as the most

important source of industrial finance. The dependence on bank for finance could vary according to the size of the companies and to the availability of credit at a lower cost. Mehak jumped and chipped in, Monetary policy aims to influence the overall level of monetary demand in the economy so that it grows broadly in line with economys ability to produce goods and services. He was proud for finally getting the linkage between interest rates, price level and monetary policy. Bingo said the Professor and explained This stops output from rising too quickly or slowly. Interest rates are increased to moderate demand and inflation (an increase in general price level in an economy).(Refer to exhibit 1). Akriti was in affix, what do the interest rates have to do with demand? The class was now in full swing. And the prof enjoyed answering all sorts of question from his students. He calmly replied When interest rates are changed, demand can be affected in various ways. A change in the cost of borrowing affects spending decisions. Interest rates will affect the attractiveness of spending today relative to spending tomorrow, you mean that an increase in interest rates will make saving more interesting than borrowing. This will tend to reduce the current spending, by both consumers and firms, asked a student. To this the prof replied this spending includes both spending by consumers in shops and spending by forms on new equipment i.e. investment .Conversely, a reduction in interest rates will tend to increase spending by consumers and firms. Professor Gupta smiled and went on, Monetary policy operates by influencing the price of money i.e. the cost of borrowing and the income from saving. The RBI set the bank rate. This is an interest rate for the Reserve Banks own transactions with financial institutions- the rate at which the reserve bank will make short term loans to banks and other financial institutions. And how is the bank rate so important? quipped a student. That is because changes in the bank rate affect a whole range of interest rates set by commercial banks, and other financial institutions, for their own savers and borrowers. It will influence interest rates charged for overdrafts and mortgages, as well as saving accounts. A change in the bank rate will also tend to affect the price of financial assets such as bonds and shares. Professor Gupta read the quizzical look on the face of his students. He went on. These changes in the financial markets affect consumer and business demand, and in turn, output. Changes in demand and output then have an impact on the labor market employment levels and wage costs which in turn, influence producer and consumer prices. Mehak was confused about whether there is a positive correlation between a cut in the bank rate and movement in the interest rate. To remove their confusion Prof Gupta replied, Precisely, most banks make downward adjustment in their respective lending and deposit rates following a slash in the bank rate. He further replied while the cut in the lending rate would bring down the interest income, it is only logical that most banks would try to compensate for the loss of income by bringing down the interest outgo through adjustment in deposit rates so as to neutralize the impact on their net interest income.

Another student asked , Sir, the article also mentioned something about the assets prices and exchange rates To this the professor replied thats just like substitution effect of the simple law of demand. Higher interest rates increase the return on savings and PPFs. This might encourage savers to invest less of their money in alternatives, such as property and company shares. Also any fall in demand for these assets, which, in turn, might influence their willingness to spend. Again, lower interest rates have the opposite effect; i.e. they tend to increase the assets prices. Similarly, a significant fall in in the interest rates can be expected to reflect in higher stock prices. The professor wrapped up the session after answering all questions.

Case Questions: 1. 2. 3. 4. Discuss the importance of interest rates. Discuss the monetary policy in detail and important learnings from the case. Analyze exhibit 1 and its possible consequences. Analyze the chart below and its impact on the Indian economy over the years.

Chart historic CPI inflation India (yearly basis) full term

Table historic inflation India (CPI) by year