Anish Das is a first-year economics student at the Jindal School of Government and Public Policy. His interests include capital markets, foreign policy, and public finance. He is currently a Content Writer at Arthaniti – JGU’s Economics Society.
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My local convenience store back home in Bangalore is the filled to the brim with cheap junk food. It has been the one-stop destination for countless ill-advised midnight sojourns of this nouveau college student fuelled by unhealthy cravings. Recently though, these trips have reduced significantly. Not out of some earnest self-improvement drive, but due to the discovery that my once beloved hoardings of Blue Lays and Diet Coke were no longer a tiny blip on my admittedly limited budget.
Having written it off as a purely local occurrence, I had set out to find a new stomping ground. Imagine my displeasure when I discovered that nearly every store, I visited seemed to have increased prices significantly. I was initially disappointed, but my curiosity was piqued. As I set about rejigging my diet, I wondered: What was driving this? Even more importantly, who? Was there some secret cabal of shopkeepers operating under the radar? Who was to blame? And more importantly, how do we fix it?
It takes money to buy money?
To better understand the underlying mechanisms, it is helpful to think of money just like any other good [like a Diet Coke]. A shopkeeper sells each unit of Diet Coke at a given price. His objectives are to cover the cost of producing/sourcing Diet Coke while also making a profit. Similarly, banks are in the business of selling(lending) money. When banks lend money [to consumers, businesses, other banks], they expect to be repaid the amount they have lent - called the principal, and a percentage of that principal- to make a profit. That percentage is called the interest rate.
Interest rates are the cost of borrowing (buying) money. While the exact rates differ across different types of loans, the idea remains the same- an interest rate is a price you pay to borrow money. When the price of a Diet Coke goes up, people buy fewer Diet Cokes. Analogously, when the interest rates (the price of money) go up, people buy less money (take less loans). When interest rates are low, borrowers find it easier to pay back loans. Hence, they will borrow more (buy more money) and spend more (use the money).
When interest rates go up, borrowers borrow less, and subsequently, the spending goes down.
The chase begins
Let us now discuss why increased spending levels in an economy are significant. Increased spending implies more demand for goods [eg. Diet Cokes] and services. Resultantly, businesses bolster their production(supply) capacity and hire more people (unemployment decreases) to meet increased demand. Increased employment leads to more money in the hands of those employed, leading to further increases in spending on say, Diet Cokes, (among other things) and the cycle repeats. This essentially leads to economic growth - an increase in GDP [amount of goods and services produced in a country]. However, this cycle has a caveat. Increased spending may lead to uncontrolled inflation (rise in the general price levels).
How? Suppose interest rates decrease. People will borrow more and hence spend(demand) more on goods, say Diet Cokes. Meaning: There is a greater quantity(supply) of money in the economy chasing/demanding the same quantity/number of Diet Cokes. Previously, one Diet Coke was worth Rs.20. Say five individuals could afford to pay Rs.20 for a Diet Coke. After the money supply in the economy increases, more individuals (say 10) can pay Rs. 20 for a Diet Coke. Thus, a greater quantity of money (10*20=200) is chasing one can of Diet Coke, as compared to before.
In response to this increased demand, firms raise prices. This process can get out of hand very quickly if interest rates are kept low enough to facilitate a sustained flow of credit (borrowed money) in the economy- leading to very high inflation [Note: Most economists say a 2% inflation rate is good for the economy]. Most central banks [Eg: RBI, the Federal Reserve] cannot directly influence the rates commercial banks charge customers. Therefore, they manipulate interest rates by changing the money supply [more on that later]
Think about it this way: If the supply of Diet Cokes suddenly increased, there would be lot more Diet Cokes available in the market than before. Because the customer now has more options, they will look for a shop that offers them the best deal -the cheapest Diet Cokes possible. Shops, therefore, sell Cokes at lower prices to compete with other sellers. Analogously, if the central bank increases the money supply, there will be a lot of money for banks to lend out.
Borrowers would look for the best(cheapest) deal possible in terms of the rates offered. Consequentially, banks lower interest rates to compete with other banks(shops). Decreasing the money supply has the opposite effect. Banks have less money to lend. Borrowers compete for this limited amount of money, and this pushes up interest rates (price of money). Thus, a higher money supply implies lower interest rates and vice-versa.
The central bank policy of increasing the money supply to lower interest rates and stimulate borrowing and spending is called expansionary monetary policy. Central banks adopt such policies to speed up or encourage economic growth [expansion of GDP]. Decreasing the money supply to increase interest rates, and lower the level of borrowing and spending, is known as contractionary monetary policy. Central Banks use contractionary policy usually to bring inflation under control.
Sentence first, verdict afterwards
There are several tools a central bank can employ to change the money supply.
Reserved!
Every commercial bank is mandated to keep a percentage of the deposits it receives as reserves- and is free to lend the rest out. This percentage is known as Reserve Requirement. [Fractional Reserve Banking]. The central bank can change the money supply by changing these reserve requirements. Decreasing the reserve requirements leads to an increase in money supply as banks can lend out more of their deposits. The opposite effect is observed when reserve requirements are increased.
Interest-ing
Secondly, the Central Bank is the banker’s bank- meaning that if a commercial bank needs money, it can borrow from the central bank. The Central Bank can change the interest rate it charges commercial banks [known as the Discount Rate in the US- closest Indian equivalent is Repo Rate]. If the Central Bank decreases the interest rate, it makes it easier for banks to borrow, thus increasing the supply of money in the economy. Once again, the opposite effect occurs when the rate is increased.
Bonding openly
The third practice, Open Market Operations (OMO) is a policy tool wherein central banks buy and sell short-term bonds. To increase the money supply (to lower interest rates)- central banks will purchase bonds from banks thus increasing the amount of funds banks can lend to customers. More funds (supply) in the bank lead to falling interest rates and a cycle of increased spending and economic expansion [as discussed before]
The opposite case is when Central Banks sell bonds to banks. Money is taken out of the economy, leading to higher interest rates. Borrowing becomes less attractive, and spending levels reduce- leading to lower levels of economic growth. [Usually done to combat high inflation rates]. Securities trading is one of the most effective ways to control economic activity.
Easy Money
The final and the most unconventional practice is known in economic parlance as Quantitative Easing (QE). This involves controlling the quantity of money by easing pressure on the banks. This is done in one of two ways. First, the Central Bank buys risky assets of the banks such as bad debts, debt-backed securities, etc. This reduces (eases) the pressure on the banks by reducing their proportion of risky assets and leads to an influx of funds into the banking system. Second, the Central Bank buys long-term government bonds on the open market. By increasing the demand for these bonds, the yield (interest rate paid) on the bonds falls (bond prices and yields move inversely)
The goal is to disincentivize banks from buying these bonds. [Government Bonds are viewed as a safe investment and an opportunity to earn interest]. By driving down the yield, the central bank hopes to get banks to look for other opportunities to make money- lend more liberally to those who need it(customers and businessmen) and will pay higher interest than bonds. By utilizing QE, Central banks hope to increase the money supply (greater flow of credit) in the economy and spur economic growth.
Of you and me— and central banks —And whether prices have wings.
Regardless of who you are- a new graduate entering the world of work, a retiree, or a well-established professional, it is vital to understand the forces that affect your daily life. So next time you are tempted to think of galloping prices as the reincarnation of the queen of hearts screaming, “Don’t let her get away, off with her head,” remember monetary policy. While you may no longer be able to buy as much Diet Coke as you want, at least you'll know why.
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