Inflation and Interest Rates - Excellent Explanation by Raghuram Rajan

Nice article by Dr. Raghuram Rajan, RBI Governer
Inflation, Interest Rate and Raghuram Rajan's Dosa Economics:-

Interest rates are always a source of conflict. Borrowers demand low rates. Fixed Depositors desire high rates.

In such a scenario, what should RBI do?

This was beautifully explained by the RBI Governor Dr.Raghuram Rajan with the example of Dosas.

The basic premise of Dr. Rajan's argument is quite simple - one should NOT look at the interest rates in isolation. This will give the wrong picture.

Instead, to assess whether we are better off with high interest rates or low rates, we have to consider the "inflation" factor.

Let us look at Dr. Rajan's example of Dosas to understand this link between interest rate, inflation and our well-being.

Situation on Day 1
Bank balance - Rs.1,00,000
Price of Dosa - Rs.50
No. of dosas you can buy - 2,000

Situation after 1 year
(a) Case 1 (Interest - 10%, Inflation - 10%)
Interest earned - Rs.10,000
New Price of Dosa - Rs.55
No. of dosas you can buy with interest income - 182

(b) Case 2 (Interest - 8%, Inflation - 5.50%)
Interest earned - Rs.8,000
New Price of Dosa - Rs.52.75
No. of dosas you can buy with interest income - 152

Most people look at this picture, and declare themselves as worse off with lower rates. Due to reduced interest income, they can buy less number of dosas. Hence, they always cry and crib for the higher interest rates on their fixed deposits.

This, however, is a mistake:

They fail to account for the impact of inflation on the principal amount.

Is inflation 'rapidly' squeezing the purchasing power of your money?

Situation after 1 year (with principal included)
(a) Case 1 (Interest - 10%, Inflation - 10%)
Interest earned - Rs.10,000
Total savings - Rs.1,10,000
New Price of Dosa - Rs.55
No. of dosas you can buy with interest income - 182
No. of dosas you can buy with principal - 1818
Total number of dosas you can buy - 2000

(b) Case 2 (Interest - 8%, Inflation - 5.50%)
Interest earned - Rs.8,000
Total savings - Rs.1,08,000
New Price of Dosa - Rs.52.75
No. of dosas you can buy with interest income - 152
No. of dosas you can buy with principal - 1896
Total number of dosas you can buy - 2048

Clearly, the interest rate on your fixed deposits - in absolute terms - is not relevant at all for your good financial health.

Instead, the positive difference between interest rate and inflation, is far more critical number to focus your attention on.

In Case 1, the difference between interest rate and inflation is NIL. Whereas, in Case 2 the interest income is 2.50% more than the inflation.

This is the real earning:

Since in Case 1, the real earning is nil, you can buy the same number of dosas after one year.

Whereas in Case 2, where the real earning is 2.50%, you can buy 48 "more" dosas after one year (despite earning lower interest).

Learn: Inflation Demystified

Therefore, fixed depositors should not be fixated on the interest rates alone. They should appreciate that the real value of their principal is depleting day-by-day due to inflation.

As you can see, because of this inflation, your principal of Rs.1 lakh can buy you only 1818 or 1896 dosas after one year, as compared to 2000 on Day 1.

This erosion in the value of your principal is a serious threat. Therefore, it should form an integral part of all your financial planning. This would enable you to live comfortably, without significantly downgrading your standard of living.

Beware : Blind Faith In Fixed Deposits Is Destroying Wealth

In fact, I often get mails from my readers that they want to quickly become a crorepati, so that they can retire and live happily ever after.

And I send them a detailed calculation, as to how they would become beggars within 10-15 years. This seemingly huge amount of Rs.1 crore would surely and steadily shrink to ZERO.

Hence, it is imperative that you must consider the (negative) impact of inflation, in your retirement corpus calculations. If not, you will be in for some serious financial trouble, in the later years of your life.

This is precisely why the central banks world over target a moderate inflation. Since inflation hurts the aam aadmi the most, RBI too focuses all it efforts and endeavours on keeping the inflation low.

Solution: How To Earn Tax-Free Risk-Free Income

You have now been forewarned about the disastrous effect of the silent killer inflation. Therefore, you must ensure that your investments earn real positive income and not just high notional interest.