India's Recovery via Interest Rates

Raguram Rajan, Central Bank Governer

India's booming development has taken a bit of a U-turn in recent month as the economy has been hurt by many factors. With growth rates slowing down, especially in key sectors such as manufacturing and mining, the economy is in desperate need of recovery if it is going to continue to live up to it's reputationas one of the best developing countries for years to come. Plus the government have failed to influence foregin investors from staying in the country by not improving their economic relationship with the USA. However the road to recovery has begun. The new Central Bank Governer, Raguram Rajan, has raised interest rates from 7.25% to 7.5%, in the hope of curbing inflation in India which hit a six month high of 6.1%. It's all good raising the interest rates but whats the economics behind it? With interest rates up, consumers are influenced to save more and spend less as they will get a higher return on their savings and the cost of borrowing is higher. Inflation is the increase in the general price level and is mainly caused by high consumer spending. Therefore, by raising interest rates to lower consumption they will be able toreduce the rate of inflation, however a short term negative effect will be a reduction in aggregate demand due to the reduction in consumption. On the other hand the reduction in consumption could be offset by the increase in investement that results from the rise in interest rates. Rising interest rates means foreign firms can invest in India as their returns will be higher.

As the graph shows, a fall in interest rates leads to a rise in inflation due to a lower cost of borrowing so consumers are spending more. Mr Rajan is hoping the same principle will apply in reverse with his latest scheme so that consumer spending falls with the rise of interest rates therefore lowering inflation in India.