Understanding inflation and how it can be controlled by tweaking interest rates

The Reserve Bank of India recently raised interest rates, citing inflation as the reason for the increase. So, what exactly is inflation? What impact does it have on the average person?

Shailesh Khanduri
23 Jan 2023
Understanding inflation and how it can be controlled by tweaking interest rates

Representative Image

New Delhi: In our daily lives, we hear the word “inflation” a lot, whether it’s in the newspaper, on social media, or even when the housemaid reminds us to raise her salary because inflation affects her as well. The Reserve Bank of India (India’s central bank) recently raised interest rates, citing inflation as the reason. So, what exactly is inflation? What impact does it have on the average person? Let us look into it.

Understanding demand and supply

Before delving into the concept of inflation, let us first define demand and supply. Supply and demand determine the price of a product or service. So, if a product has a plentiful supply but low demand, the price of that product or service is bound to be low, and vice versa. When demand and supply are balanced, however, the price is expected to be reasonable. For example, if a bag of walnuts costs Rs. 100, there are two options.

  • They are being sold at a discount because the seller has an abundance of stock and wants to get rid of it before it goes stale and unfit for sale.
  • Because apple demand is extremely low, the seller is attempting to attract customers by selling them at a low price, thereby enhancing the demand.

In both cases, the dry fruits seller will gradually raise the price as demand increases and will stop raising the price when demand appears to be decreasing. Regardless of which example you use, the effort to achieve equilibrium in demand and supply levels is at stake. This equilibrium is simply the point at which both the seller and the buyer are satisfied with their options to sell or buy.

Defining inflation

To begin, everyone has limited purchasing power, which means he or she can only spend a certain amount. Nothing can be used to substitute the items needed for daily living including food, clothing, and shelter. Imagine how a sudden surge in price due to inflation does to them. Inflation enters the picture due to our limited purchasing power and the unavoidable demand for basic necessities. Until and unless supply exceeds demand, prices remain affordable and inflation remains under control; however, once prices begin to rise, demand begins to decline; however, demand can never be extinguished because basic necessities are involved.

Technically, price increases have no limit, but as previously stated, purchasing power does, so exponentially rising prices could leave people begging for basic necessities and jeopardise the economy. Before such a crisis occurs, the government provides relief by enacting various inflation-controlling measures such as export bans, lower fuel prices, price management of essential commodities, and so on.

Effect of interest rates

While the government uses the aforementioned measures outlined above to control inflation, the Reserve Bank of India (RBI) has another tool in its arsenal to keep inflation at bay. The RBI is the country's central bank, lending money to other financial institutions and banks. However, before we consider the impact of interest rates, we should consider purchasing power and inflation. As previously stated, there will always be a demand for basic necessities, but limited purchasing power complicates matters. As a result, if prices rise, an individual can use his or her borrowing power to make up the difference.

To put it simply, if the price rises, we will borrow and buy, but here's the catch: you can only borrow up to the value of your assets, limiting your borrowing power. The RBI now carefully balances both situations depending on the economic situation. When the economy is weak, lending rates fall, and banks follow suit in order to boost purchasing power and create demand. When demand exceeds supply, the lending rate rises to reduce purchasing power and, thus, demand in order to lend stability to the economy.

Using interest rates to control inflation

The Reserve Bank of India lends money to banks. The banks will in turn lend at a higher interest rate if funds are borrowed at a higher interest rate, and vice versa. As a result, whenever the RBI raises interest rates, banks adjust their lending rates immediately. Higher loan costs result in lower spending, which results in lower demand and, eventually, more savings. In the opposite direction, as borrowing rates rise, so does the rate of interest on secured investments, resulting in increased earnings or savings.

To summarise, demand, supply, interest rates, and inflation are all interconnected, and inflation cannot be avoided. As a result, the only way forward is to achieve demand-supply equilibrium.

Read The Next Article