Fundamental economic theory propounds that inflation is caused due to excess money chasing fewer goods. Hence, Central Banks adopt the stand of increasing the interest rates to suck the excess liquidity out of the system. How this works is as follows.
When interest rates rise, Banks offer higher interest to the depositors, which makes it attractive for the investors to invest in Bank debt instruments like FDs', rather than in other areas like Stock market, land etc, and they curtail spending to save. If the Central Bank also decides to increase the SLR and CRR, then Banks are forced to retain additional cash in the system. Another consequence of raising the interest rates, are that Banks are forced to raise the lending rates, making it unattractive for the industry and business to go for debt financing for their expansion schemes. The alternate route of raising through stock market is ruled out as investors, as I said earlier, has moved away from the more risky stock market to the less risky debt instruments. Thus industry is starved of funds, forcing them to cut production or at the least withhold expansion plans (you have to remember that an inflationary economy is good for the industry, as they are getting more value for their products in the market). The reduced production, coupled with liquidity being sucked out of the system, means economy slowing down, less money chasing less goods (same goods) leading to reduction in prices.
But then with RBI increasing the interest rates 12 times in 18 months the inflation has not come down one bit. Why is this so?
One of the reason is that Government has allowed Indian industry to raise money, through equity or debt, from the Global Markets which are currently under recession, and the western countries have abysmally low interest rates. Thus the industry has enough and more money to fund their expansion, and this money finds its way to the market one way or other, leading to further inflation. And with double digit inflation prevalent, they are laughing all the way to the banks, as their products are selling at higher rates day by day.
Only people who are affected? The common man, mainly the middle class, who find their EMIs on housing and vehicle loans going up month after month, with no relief in site.
I was once the franchisee of a leading IT training company in the 1990's. Their only objective was to ensure that whenever I clear by debts and start earning some profits, by introducing either a syllabus change or introducing some scheme, they will ensure that the money is taken from my pocket to theirs. At least I had the option of exiting the business then, which I did, but the aam admi of India has no place to go to.
