Question

“Request the central bank to raise interest rates. We acknowledge monetary policy considerations by the Central Bank are always finely balanced amongst lowering inflation, safeguarding the balance of payments and supporting economic growth. The Ministry of Finance will request the Central Bank to have monetary policy cooperate with fiscal policy as far as possible by raising the repo rate. This will send a signal for the transmission of higher and rising interest rates throughout the financial system including an increase in savings and deposit rates. Higher domestic interest rates will help to limit capital outflows and improve foreign exchange availability. It will also help depositors and pension funds struggling with real negative returns in the low interest rate environment of the past decade.”

Is this strategy likely to succeed or fail?

Answer 1

The rate at which the central bank, in case of shortage of funds, lend money to the commercial banks is known as repo rate. It is a powerful tool for controlling the money supply in the economy. The central bank increases the repo rate during inflation and reduces it when the economy experience lower rate of inflation.

An economy experiences inflation when there is more supply of money. So in order to reduce the money supply, the central bank increases the repo rate. Once the repo rate is increased, the commercial banks will find it difficult to borrow money from the central bank.

Along with an increase in the repo rate the economy will also witness an increase in the market interest rate also. This will affect the consumption and investment adversely. Thereby, the demand for the goods in the economy decreases.

The changes in the repo rate also affects the prevailing exchange rate in a country. When there is an increase in the repo rate along with it the market interest rate also increases. This will in turn increases the exchange rate of the currency. Thus now imports of goods increases and there will be a reduction in the exports. That means there is a decrease in the prices of the imported goods in the economy. Thus, again it will lead to a lowering of the price level. But this strategy will hinder the exports of an economy.

It is also true that the foreign investment also increases with higher interest rate. So, the policy will be successful if there is a balance between increase in the interest rate and the rate of inflation.