Part A: Meaning and methods of measurement of the concepts.
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Inflation: Inflation in an economy is said to occur when the prices of the goods or services increase in the economy such that the other factors leading to price rise are constant. In simpler terms, it can be defined as the rate at which prices in the economy increases. The prices of products might also fall with time, this concept is called deflation.
The primary reason for this increase is that the value of $ 1 received today will be more than the value of $ 1 received after 10 years. To account for the time value of money, prices of the products increase and thereby bringing inflation in the economy. Other reasons for inflation in society can be:
Growth in the economy.
Increase in supply of Money.
Rules and regulations of the government.
Changes in currency exchange rates.
Management of national debt etc.
Inflation in an economy can be measured by using various concepts. The most prominent amongst these methods is that of CPI or the Consumer price index. Using CPI, the inflation rate in the economy can be measured by the formula:
(t)/ C (o) * 100
Where price index in the current period
C of market basket in current period
C of the market basket in the base period
Other methods include:
CPI, less food, and energy – The CPI is calculated ignoring the amount spent on food and related products since these prices fluctuate frequently and are not a reflection of the country’s economy in the long run since these fluctuations are mostly due to changes in weather patterns.
Personal Consumption Expenditure or PCE: This method considers the amount that the consumer spends on the day-to-day requirements and how they vary from year to year.
Personal Consumption Expenditure, less food, and energy: This measure also considers consumer spending habits rather than prices of products. However, it excludes variation in food and related products.
Interest Rates: Under any economy, there exists a gap between people who have money and people who need money. This gap is bridged through certain institutions like banks and other financial institutions that borrow money from people that have extra and lend them to people who need it. For this, the bank charges interest from the borrowers andat higher rates and pays interest and lower rates to the lenders. Therefore, interest rates come into force.
In short, interest is nothing, but an amount paid by the user of funds to its provider in consideration for allowing the use of money. Interest rates in the economy can be measured in two ways:
Nominal interest rates: This is the rate of interest that is provided on the deposits made or loan taken. ( Anghel, Et. Al., 2017) This is the actual rate that the central bank of the country has decided for the country and does not consider the effect of inflation or deflation or any other economic issues.
Real Interest rate: This is the actual effect that the amount spent or earned has. This is because the value of currency changes continuously due to the effects of inflation or deflation.
Fisher’s equation can be used to establish the correlation between the nominal interest rate and the real interest rate.
real interest rate ≈ nominal interest rate − inflation rate.
It can be seen from the above equation that the real interest rate can be calculated by subtracting the inflation rate (or adding deflation rate) to the nominal interest rate. This way, the effect of inflation is removed, and the actual amount of interest can be considered.
It must be understood that the real interest rate is just a theoretical concept and that the consumer needs to pay the nominal interest rate itself.
Part B: Comparison of data for economies of India and Australia
Inflation:
The inflation rate in India is monitored and calculated by the “Ministry of Statistics and Programme Implementation”. Inflation rates in India are generally calculated by considering the “Wholesale Price Index” or WPI (Goyal, A. and Parab, P., 2019). For calculation, a basket of goods is considered by taking its wholesale price. The products in the basket are taken as:
Primary Goods: 22.2 %
Power and fuel: 13.15 %
Manufactured goods: 64.23 %
These figures are measured every month by the Ministry of Commerce and Industry.
The rate of inflation in India can be depicted in the graph below:
It can be seen that inflation chart is showing an upward trend and the rate of inflation if quite high at 7.35 % in 2020. The government and Reserve Bank of India try continuously to bring this figure under control. The inflation is 2019 was close to 2 %. The main reason for such a drastic increase is the uncertainty created due to the pandemic situation created by COVID-19.
Inflation in Australia
The Australian Economy is one of the Biggest economies of the world, having minimum inflation rates.
The RBA uses Consumer Price Index model or CPI Model to monitor the inflation in Australia. A basket of commodities is identified and its price monitored to measure the inflation accurately.
The inflation rate chart of Australia is as below:
It can be seen from the above that the rate of inflation in Australia is Negligible. The Governor of the State, along with the Reserve Bank of Australia aims to bring this to 2 % - 3 % over time, since as discussed above, the NIL rate f inflation is also not a healthy sign for the economy.
The inflation rates in Australia are in Stark contrast to the rates in India. The rate in India is as high as 7% while that of Australia is as low as 0%. Both the countries aim to target inflation in the 2-3 % bracket in the long run.
Rate of Interest
Rate of interest in India: The Reserve Bank of India is the central bank of India, that decides the monetary policies of the country. The RBI is responsible for the fixation of the rate of interest on lending for the country. The RBI determine the REPO rate, i.e., the rate at which commercial bank can borrow money from the reserve bank (Asbe, C., 2019) At present, the Repo rate is constant at 4%. Reverse Repo Rate, on the contrary, is the rate at which RBI borrows money from commercial banks. These rates are generally altered by the RBI from time to time to meet the monetary requirements of the country and to counter inflation rates. The movement of repo rate in the country can be seen from the graph below:
As evidenced from above, it is seen that the bank repo rate has fallen for the country and is not at 4.4%. These rates are altered to counter the inflationary conditions of the country.
Rate of interest in Australia:
The interest rate in Australia is very close to 0 % (Hsing, Y., 2019) In fact, the Reserve Bank of Australia is recently considering the implementation of ZERO Interest Rate Policy or ZIRP to counter the deflationary conditions created due to COVID – 19. The interest rate movement of the country is displayed in the graph below:
It is clear from above that the rate of interest is falling continuously. This lower rate of interest is planned by the country to that the 0% inflation rate of the country could be increased to match up the target inflation.
Part C: Link between inflation and interest rate and its relation to monetary and fiscal policy
Monetary Policy: monetary policy is the one that is defined by the reserve bank of any country % in to monitor and control the flow of liquidity in the economy. It is very important for the economy that the movement of cash in the country is properly regulated and accounted for.
Fiscal Policy: Fiscal policy is defined by the government of any country and considers other aspects like taxation, government spending, subsidies, employment, etc (Chugunov, I.Y., and Pasichnyi, M.D., 2018). The power to make such decisions lie with the government and these policies are changed frequently, depending on the conditions in the economy.
Both these policies are drafted at the central level after considering all the relevant macro-economic factors and prospects of the country.
There exists an inverse correlation between inflation and the rate of interest in the economy. This is because when the rate of interest is low, people tend to spend money instead of investing since the return on investment is very low. This leads to increased cash flow in the economy which leads to inflation. Inversely, if the rate of interest is high, the propensity to spend will fall and people will invest more to earn higher returns, thereby reducing the flow of currency.
When inflation is high, the central bank and government draft its fiscal and monetary policyto reduce it. One of the tools available is to increase the rate of interest in monetary policy. If the rate of interest increases, people will tend to invest more, and this will reduce inflation. Other options available with the government are to
Increase consumption tax.
Reduce governmental subsidies.
Increase the requirements to maintain reserves with the central bank.
By introducing a mix of these policies, the government tries to cater to the increase in prices in the economy since higher rates of inflation are generally a negative sign for the country.
When inflation is low or in the situation of deflation, monetary and fiscal policies are drafted to increase the rate of inflation. Deflation in the economy is never considered a healthy sign. Controlled levels of inflation are always desired in any economy. This is because a situation of deflation means that the currency value of the country is not very strong and such economies cannot sustain much.
Therefore, government and central banks also plan these policies to increase inflation. In such cases, the government generally decreases the rate of interest so that people are discouraged to invest and rather spend. Other policies that may be opted by the government include:
Reduce tax rates for consumption
Increase government subsidies to increase cash availability
Reduce reserve requirements of banks with the central bank.
Therefore, we can identify that the country’s inflation rates and interest have a negative link and that government does changes its monetary and fiscal policy to control, the inflation situation in the economy, which includes alteration of rates of interests prevailing.
Conclusion
From the above report, it is concluded that there exists a negative correlation between the rate of interest and inflation in the economy. Inflation is said to exist if prices of commodities increase in the economy without any actual increase in any other price-related factor. The increase is only because prices of all other products increased as well. The rate of interest is what is paid by the bank to its lenders for the amount they deposit in the bank. The central bank, in its fiscal policy, seldom alters the interest rates to keep the inflation level in check.
References
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Anghel, M.G., Lixandru, G., Popovici, M., Solomon, A.G. and Stanciu, E., 2017. Theoretical Elements on the Use of Price Indices for Inflation Measurement. International Journal of Academic Research in Accounting, Finance and Management Sciences, 7(3), pp.38-47.
Asbe, C., 2019. Role of Repo Rate in Indian Monetary Policy Since 2014. Editorial Review Board.
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Chugunov, I.Y. and Pasichnyi, M.D., 2018. Fiscal policy for economic development. Scientific bulletin of Polissia, 1(1 (13)), pp.54-61.
Fama, E.F., 2021. Short-term interest rates as predictors of inflation. In The Fama Portfolio(pp. 502-523). University of Chicago Press.
Goyal, A. and Parab, P., 2019. Inflation convergence and anchoring of expectations in India(No. 2019-023). Indira Gandhi Institute of Development Research, Mumbai, India.
Hsing, Y., 2019. Is Expansionary Fiscal and Monetary Policy Effective in Australia?. The Journal of Business Economics and Environmental Studies, 9(3), pp.5-9.
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