The affiliation between Banking and Inflation

Hello Friends,

First of all, I would like to thank you all, for enormous response and giving precious suggestions and valuable tips in my preceding article.

After sharing my study experience in earlier article, decided to write a fresh article on topic which is very widespread and imperative for Commerce field students, by using my own familiarity to some extent and gathering essential information from reliable source.

Every commerce student is well versed with commerce related knowledge in depth, like Finance field, Taxation, Banking, commercial & legal laws etc, its inclusive of familiarity  regarding banking, inflation rates and varying interest rates too.

Banking (Fluctuating interest Rates) and inflation rates are very important rudiments in current economy as whole.

Well, coming to the point, would like to tell There is a strong correlation between interest rates and inflation. Interest rates reflect the cost of money, such as the rate you pay when you borrow money to buy a house or spend on your credit card. Inflation is the cost of things.

Meaning Of Inflation:

A simple commonly used definition of the word inflation is simply "an increase in the price you pay or a decline in the purchasing power of money” that’s it.

Further, In two ways Inflation can be explained neither mutually exclusive. One way to think about inflation, the increasing cost of things, is too much money chasing too few goods. In essence, this bids up the price of the goods, inflating their cost.

The other way for prices to go up could be that production costs go up. A labour union negotiating a contract for a higher wage, for example, could cause the cost of the product the union members produce to increase, or inflate.

In simple terms, the word 'Inflation' refers to a growth or increase in money supply. As one of the important economic concepts, the effects of inflation exert impact both in the economic and social spheres of a nation and on its inhabitants.

Interest Rates:

Generally, interest rates and inflation are strongly related. Since interest is the cost of money, as money costs are lower, spending increases because the cost of goods becomes relatively cheaper.

Interest rates measure the price of borrowing money. If a business wants to borrow Rs. 1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time.

The Relationship:

Interest rates are the rate of interest you receive or pay depending whether you save or borrow money respectively.

The higher the interest rate the more expensive it becomes to borrow money and the more attractive saving becomes.

If your bank decided to double the interest rates on your savings account you will be more likely to put more in it. thus the higher the interest rate the more money is restricted from the money supply having an adverse effect on inflation.

If numerous people can purchase the same house, the price of the house is likely to increase because there are several prospective buyers.

In other words, the cheaper cost of money drives up (inflates) the price of the home. Historically, you can plot the correlation between interest rates and inflation and see that there is a strong positive correlation between the two.

Inverse Relationship:

Of course , there is typically an inverse relationship, high interest rates equals low inflation, low interest rates equals high inflation.

Why its so? Money, if there is more money in an economy, people tend to spend more,. If there is less money in an economy, there is less to spend and low demand equals lower prices. Simple concept.

If interest rates are low, money is easier and cheaper to borrow, hence more money in an economy. If rates are high, it is more expensive to borrow, hence less money in an economy.

Stagflation:

There is also a concept know as stagflation, when interest rates and inflation both increase, such was the case in the Carter Administration. External market factors or market manipulation may cause stagflation.

Effects On Time Value Of Money:

As we all know, the simple meaning of TVM is “The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity”.

Price Inflation greatly effects time value of money (TVM). It is a major component of interest rates which are at the heart of all TVM calculations.

Actual or anticipated changes in the inflation rate cause corresponding changes in interest rates. Lenders know that inflation will erode the value of their money over the term of the loan so they increase the interest rate to compensate for that loss.

Highlights of RBI Monetary Policy Review for first quarter of the financial year FY2010-11:

• The Bank Rate has been retained at 6.0%
• Repo rate increased by 25 bps from 5.5% to 5.75% with immediate effect
• Reverse repo rate increased by 50 bps from 4.0% to 4.50% with immediate effect
• Cash Reserve Ratio (CRR) of scheduled banks has been retained at 6.0% of their net demand and time liabilities (NDTL)
• The projection for WPI inflation for March 2011 has been raised to 6.0% from 5.5%
• Baseline projection of real GDP growth for FY2010-11 is revised to 8.5%, up from 8.0% with an upside bias
• M3 and non-food credit growth projections for FY2010-11 have been retained at 17% and 20% respectively
• Mid-quarter review of Monetary Policy to be a regular event beginning from 16 September 2010
• In essence the RBI announced no hike in CRR and a 25 bps (bps) increase in Repo rate but a 50 bps hike in Reverse Repo rate was not expected by many.

The RBI said that the Monetary Policy actions are expected to:

• Moderate inflation by reining in demand pressures and inflationary expectations.
• Maintain financial conditions conducive to sustaining growth.
• Generate liquidity conditions consistent with more effective transmission of policy actions.
• Reduce the volatility of short-term rates in a narrower corridor.

Conclusion :

Dear Friends !  I have tried my level best to elucidate the basic concept and relationship between varying interest rates (banking) and inflation rates. If I am missing anything essential, please let me know.

Always waiting for yours valuable suggestions and comments.

Thanks and Regards

SAN …