Increasing interest rates does not reduce/lower Inflation.-Emerging Economies.

                   THE FREEMEN

Lies being taught;

By increasing rate of interests, inflation is reduced

OR

To reduce inflation, increase rate of interests.

Now the facts;

Increasing rates of interest is expected to reduce demand whereas in fact it reduces supply apart from increasing cost.

 

What causes Inflation; Traditional view as stated per advanced economies; 

When demand outstrips supply leading to higher prices as prices are a function of demand and supply.

Steps suggested by traditional economists to reduce Inflation;

Increase rate of interests; Increase in rates of interests will reduce demand as consumers (both individuals and firms) will be lured by high rate of interest on their savings, they will thus save more and spend less leading to moderation in demand and thus decrease in Inflation. It is also said that by increasing interest rates, makes it less attractive for people to borrow (to spend) which in turn curbs their spending habits leading to decrease in demand. Thereby leading to overall moderation of Inflation.

Kaps theory;

What causes Inflation; when supply is unable to meet Demand or costs of supply have increased leading to higher prices as prices are a function of Supply unable to met Demand plus costs of Production. 

According to me increase in rates of interests leads to decreased supply thereby leading to persistent or hyper inflation in economy as seen in India in last more than a year.

A)     Increase in rate of interests leads to overall increase in costs

i)       Cost of production;

Each and every business is dependent on debt for their production. Every increase in interest rates leads to increase in their costs of debt which they will have to pass on the consumer leading to inflation in economy. This is particularly true of emerging economies like India and china where large number of people live in slums and have meager expenses and no disposable income for savings. Rather we have to encourage people to have basic necessities of life including at least three  wholesome meals, education and health. There also must a constant up gradation of standard of living. For example; a person who has cycle must upgrade to scooter. Person on scooter must upgrade to car. Person on car must upgrade his car.

Some businesses may even be working on very low margins. Increase in cost of debt may lead to;

a)     Their declaring bankruptcies,

b)     Closure of factories,

c)     Increased unemployment,

d)     Increase in non productive assets.

ii)     Cost of supply; Increase in cost of debt will also lead to overall cost of product. Transporters run their business on debt. Similarly traders, middleman also buy on debt. Any increase in cost of debt will ultimately lead to rise in their costs which would have to be passed on the consumer.

Whereas in India Rate of Interests have been increased 12 times in last year, there is slowdown in industrial production leading to widening of gap in demand and supply.  At 4.1%, the Index of Industrial Production (IIP) is at its second-lowest level in the last 17 months. This only proves that increasing of Interest rates does not necessarily reduce gap in demand and supply but in emerging economies like India and china it may actually widen the gap in demand and supply leading to persistent or Hyper inflation as seen in India

Hence in large and emerging economies like India and China, increase in rate of interests will not necessarily lead to lower cost but is most likely lead to higher cost and lower supply, thus persistent or higher inflation.

Kaps