In this article I will try to explain relation between interest rate and inflation.
Before starting let me put down some numbers as of March 2017 total amount of bank notes in circulation was 13,102 billion rupee and 250 rupee coins were in circulation. It means total currency in circulation in March 2017 was 13,252 billion rupee. (source)
Total internal and external debt of Union government as on 31st March 2018 is estimated at 82,32,653.56 core rupee which is more than 7 time of total currency is circulation. (source)
Total tax revenue of central government in year 2017-2018 was 12,69,453.8 crore rupee. (source)
Total deposit in Indian banking system as on March 2018 was 114,792,883 million rupee and total credit provided by all Indian banks was 86,825,727 million rupee. (source)
Total deposit in Indian banking system is more than 8 time total currency in circulation and total debt of central government is 7 time of total currency in circulation.
Now let us see how increase in interest rate will effect the economic situation. If interest rates are increased then banks will pay more interest to depositors which will increase cash flow into economy. Since bank loans will cost more industries cost will increase and they will be forced to increase price and inflation will start increasing. Government will also be paying more interest on its borrowing which will increase budget deficit. Government will be required to print more money to cover budget deficit it will increase total currency in circulation. This way inflation increases with interest rate and decreases with interest rate. Indian government is doing a big exercise of keeping inflation in control by reducing interest rate.
Interest rates also increase with inflation. When inflation increases and interest rates does not then people will start withdrawing money from bank and government securities and start investing in commodities like gold. It puts pressure on government and government increases interest rate to attract investments. It will increase governments expenditure on interest on its debt and government will be forced to print more money and that will further increase inflation.
Increase in inflation triggers increase in interest rate and increase in interest rate triggers increase in inflation. This is a chain reaction and can lead to hyper inflation. This happened in Zimbabwe which lead to collapse of local currency and local currency had to be abandoned. Now Zimbabwe is using foreign currency as legal tender. These foreign currencies are controlled by other countries and they can print as much currency as they want and it will cause loss to people holding these currencies in Zimbabwe. Dependence of any currency not controlled by government of that country is good for that country. I don't want that situation to ever occur in India.
Before starting let me put down some numbers as of March 2017 total amount of bank notes in circulation was 13,102 billion rupee and 250 rupee coins were in circulation. It means total currency in circulation in March 2017 was 13,252 billion rupee. (source)
Total internal and external debt of Union government as on 31st March 2018 is estimated at 82,32,653.56 core rupee which is more than 7 time of total currency is circulation. (source)
Total tax revenue of central government in year 2017-2018 was 12,69,453.8 crore rupee. (source)
Total deposit in Indian banking system as on March 2018 was 114,792,883 million rupee and total credit provided by all Indian banks was 86,825,727 million rupee. (source)
Total deposit in Indian banking system is more than 8 time total currency in circulation and total debt of central government is 7 time of total currency in circulation.
Now let us see how increase in interest rate will effect the economic situation. If interest rates are increased then banks will pay more interest to depositors which will increase cash flow into economy. Since bank loans will cost more industries cost will increase and they will be forced to increase price and inflation will start increasing. Government will also be paying more interest on its borrowing which will increase budget deficit. Government will be required to print more money to cover budget deficit it will increase total currency in circulation. This way inflation increases with interest rate and decreases with interest rate. Indian government is doing a big exercise of keeping inflation in control by reducing interest rate.
Interest rates also increase with inflation. When inflation increases and interest rates does not then people will start withdrawing money from bank and government securities and start investing in commodities like gold. It puts pressure on government and government increases interest rate to attract investments. It will increase governments expenditure on interest on its debt and government will be forced to print more money and that will further increase inflation.
Increase in inflation triggers increase in interest rate and increase in interest rate triggers increase in inflation. This is a chain reaction and can lead to hyper inflation. This happened in Zimbabwe which lead to collapse of local currency and local currency had to be abandoned. Now Zimbabwe is using foreign currency as legal tender. These foreign currencies are controlled by other countries and they can print as much currency as they want and it will cause loss to people holding these currencies in Zimbabwe. Dependence of any currency not controlled by government of that country is good for that country. I don't want that situation to ever occur in India.
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