A wise man once said that Interest rates are to prices what gravity is to the apple, Let me explain.

As we understand it, inflation is a general increase in prices. If we had a dollar for every time we heard inflation, we’d only have more inflation. This brings me to the strongest reason for growing levels of inflation– an increase in money supply. (Inflation can also be called a reduction in the purchasing power of money, because a general increase in prices leaves you with a lesser quantity of the same set of goods for the same amount of money)

Why are interest rates important?

For starters, these are largely reference rates for lending a loan, usually risk free (with no uncertainty of losing money), and a spread is added to these rates (which basically gives us a higher rate to compensate for additional levels of credit risk. (the possibility that the borrower will default)

From the borrower’s perspective, Interest rates dictate what we pay (to the lender) when we borrow money to buy a house or car, decide to get an expensive education or fund the needs of a new or existing business (aka Cost of borrowing). Remember the rule of thumb, riskier the loan, higher the interest rate. This is critical in understanding how interest rates affect us and the larger economy.

Say if you were able to get a loan at an attractive interest rate compared to what banks offer it at, you would most definitely take it, either for lack of a better deal or simply to flip that loan and make a higher interest rate by lending it forward.

Your income is almost always factored into 3 buckets. Savings, investment & Consumption. Savings are cold hard cash (and the money you deposit with the bank) that lose its purchasing power over time in an inflationary environment (where prices are constantly rising). The cash you keep with yourself will lose its purchasing power inevitably, although the bank deposits will lose its purchasing power if the rate of inflation is greater than the rate of interest your bank pays you on the amount you have parked with them. (which is often lesser than the prevailing rate of inflation). Investments are interest or non-interest-bearing assets that may or may not increase in value over time, but across these investments you are expecting to make an income, which is either periodic or at a later date, which is the incentive you seek when you part with that portion of your income. Consumption is a general word for your expenditures. Bills basically. You may have noticed when you make an investment, you are essentially deferring your consumption to a future date and theoretically this depends on your inter-temporal rate of substitution. (your willingness to delay consumption)

The relation between your income and each of these components are largely dependent on your habits and behavioral reactions to changes in income. (a.k.a Marginal Propensity to Consume which means how much more will you consume for every dollar of increased income or Marginal propensity to Save which means how much more will you save for every dollar of increased income)

How do interest rates affect inflation?

Remember we talked about Banks lending to you, which means banks also need to borrow from someone. (Because they just can’t print money- That privilege is afforded to the central Bank in most economies, in our case the Reserve Bank of India). Banks make money of the difference in interest rates while borrowing & lending. The simplest way to understand this is to assume an example where the bank borrows a million dollars at say 4% per annum (from the RBI) and lends the same million to you at say 7%. That 3% of a million is their income. (Practically, they have operational expenses as well, so they’ll need to make a ton of loans to be profitable coupled with the allied services they offer like credit cards, transaction charges etc.)

Also, in reality the RBI just does not send money over to the banks as loans, it purchases securities (promise to pay at a later date) from banks at an amount, say x. and then after some days receives an amount higher than x, the difference is the rate of interest the bank pays on the amount lent by the RBI to the bank. (a.k.a Repo Rate)

No that we know exactly where the banks normally borrow from other banks or the RBI itself– which makes RBI the originator of money supply in the country. This should give you a fair idea of how they can control inflation? Simply by limiting money supply— where the RBI does that by increasing rates of interest (Repo Rate) because then the banks borrow lesser and as a result, so do we.

Here’s where the magic happens. When we borrow lesser, we save more, consume lesser and invest lesser. Let’s pick consumption. When we consume lesser, the general level of demand for products fizzles out, and so prices will have to be reduced for the demand to rise. (Since there is surplus supply), This combination of reduction in money supply and increasing Repo Rates is how interest rates decrease inflation.

[Economics 101: increasing supply compared to a constant level of demand reduces prices and increasing demand compared to a constant level of supply increases prices]

Exhibit A- The Pandemic

In events that exhibit the contagion effect (where an economic crisis or boom spreads across countries causing a ripple), such as the Covid-19 Pandemic, different tools may be used to solve the same problem across different economies.

The world’s oldest democracy in the world handed out cheques to all tax paying citizens to basically survive the day and stimulate consumption during the onset of the crisis. What does increased consumption lead to? Increased demand, and therefore inflation. Why was the inflation so prominent in countries like America? You said it. Increased money supply in combination with lower rates of interest.

In contrast, the world’s largest democracy had a slightly more controlled journey throughout the pandemic. While India also reduced rates, helicopter money was not abruptly handed to all citizens. We provided indirect benefits to businesses such as production linked incentives, marginal tax cuts and cash transfers only to the people at the bottom of the pyramid (daily wage workers and those who make a minimum wage or lesser) indirectly to stimulate consumption and started raising rates towards the end of the pandemic.

The wise man we spoke about in the beginning, is better known as Warren Buffett.

The next time someone says rates, inflation, purchasing power, rising prices or anything remotely synonymous, you know it much better than the average Joe who didn’t read this.

My name is Kreshanu Koul and thank you for reading Interest Rates 101.