Macro Economics Project

Interest Rates in India

Submitted By: Nilay Majmudar (10ESPHH010022) Richa Singh (10ESPHH010001) Ankit Gupta (10ESPHH010018)

Contents Introduction: ..................................................................................................................3 Impact on Demand: ........................................................................................................5 Identification: .............................................................................................................5 Features: ...................................................................................................................5 Effects: .....................................................................................................................5 How does Interest Rates affect Inflation: ...........................................................................7 Impacts of Interest Rates on Indian Economy and Economic growth: ....................................8 Interest Rates and the Economy: ..................................................................................8 Gross Domestic Product: .............................................................................................8 Factors leading to change in Interest rates: ........................................................................9 Impact on other variables with Increase/ decrease in interest rates(stock exchange, pvt. investment, exchange rate, consumption): .......................................................................10 References: ................................................................................................................12 References:

Introduction: What is Interest rate? An interest rate is the price a borrower (the person who borrows money) pays for the use of money they do not own. For example a person might borrow from a bank to fulfill any of his personal needs, and the lender will receive a return for postponing the use of funds, by lending it to the borrower, this return is called interest. Interest rates are normally expressed as a percentage rate over the period of one year  such as 8% per annum, 10% per annum etc. Classification of Interest Rates: Different types of classifications of interest are possible. Based on how interest is computed,

Interest is classified into simple interest and compound interest. Simple Interest: Simple interest is calculated only on the principal amount which has not

been paid yet. It is calculated by using the formula I = r x t x P, wherein is the simple interest to be paid,r is the interest rate per annum,t is the time period expressed in years for which interest is being calculated and P is the principal amount not yet paid back. Note the difference between I and r.‘I’ refers to interest income or simply interest, while ‘r’ refers to interest rate. It can be easily seen that the simple interest over 2 years on a given principal is equal to double the simple interest in one year; over three years, it is equal to three times the simple interest in one year and so on Compound Interest: Compound interest arises when interest is added to the principal, so that

The interest that has been added also earns interest for the remaining period. This addition of  interest to the principal is called compounding (i.e. the interest is compounded). A loan, for  example, may have its interest compounded every month. This means a loan with Rs 100initial principal and 1% interest per month would have a balance of Rs 101 at the end of the first month, Rs 102.01 at the end of the second month, and so on. So, the interest in the first month is Rs 1, while the interest in the second month is Rs 1.01. The frequency with which interest is compounded varies from case to case; it could for example be monthly or quarterly or halfyearly or annually and so on In order to define an interest rate fully, and enable one to compare it with other interest rates, the interest rate and the compounding frequency must be disclosed. Since most people prefer  to think of rates as a yearly percentage, many governments require financial institutions to disclose the equivalent yearly compounded interest rate on deposits or advances. For instance, the yearly rate for the loan in the above example is approximately 12.68%. This equivalent yearly rate may be referred to as annual percentage rate (APR), annual equivalent rate (AER), annual percentage yield, effective interest rate, effective annual rate, and by other terms. For  any given interest rate and compounding frequency, an "equivalent" rate for any different compounding frequency exists. Compound interest is explained with an example in Box 1.1.

Compound interest may be contrasted with simple interest, where interest is not added to the principal (i.e., there is no compounding). Compound interest is standard in finance and economics, and simple interest is used infrequently (although certain financial products may contain elements of simple interest). One other way in which interest rates can be classified is in terms of fixed interest rates and Floating interest rates

Fixed Interest Rate: If the rate of interest is fixed at the time the loan is given and remains

Constant for the entire tenure of the loan, it is called fixed interest rate. Floating Interest Rate: Interest rates on commercial loans given to companies or individuals Often fluctuate over the period of the loan. Also, loans may have an interest rate over the life of  the loan linked to some reference rate, such as PLR (Prime Lending Rate), which varies overtime.1 For example; interest rate on a loan can be fixed at PLR plus 2 percent. As the PLR changes, the interest rate on the loan would change. In such cases, the interest rates are said to be floating rate, or variable rate Other important interest rates that are used in making capital investment decisions include: •

Discount Rate: The rate at which the Central Bank charges on loans made to commercial banking institutions is known as the discount rate.

•

Commercial Paper Rate: These are short-term discount bonds issued by established corporate borrowers. These bonds mature in six months or less.

•

Treasury Bill Rate: A Treasury bill is a short-term (one year or less) risk-free bond issued by the government. Treasury bills are made available to buyers at a price that is less than its redemption value upon maturity.

•

Treasury Bond Rate: Unlike the short-term Treasury bills, Treasury bonds are bonds that do not mature for at least one year, and most of them have a duration of 10 to 30 years. The interest rates on these bonds vary depending on their maturity.

•

Corporate Bond Rate: The interest rate on long-term corporate bonds can vary depending on a number of factors, including the time to maturity (20 years is the norm for corporate bonds) and risk classification.

CENTRAL BANK OVERNIGHT INTEREST RATES TRENDS IN INDIA

Year Jan Feb Mar Apr Ma y 201 3.2 3.2 3.3 3.6 3.7 0 5 5 4 1 5 200 4.0 4.0 3.5 3.3 3.2 9 5 0 5 9 5 200 6.0 6.0 6.0 6.0 6.0 8 0 0 0 0 0

Jun Jul Au g 3.7 3.9 5 8 3.2 3.2 3.2 5 5 5 6.0 6.0 6.0 0 0 0

Sep Oct Nov Dec

3.2 5 6.0 0

3.2 5 6.0 0

3.2 5 6.0 0

3.2 5 5.2 4

Impact on Demand: Macroeconomics deals with the big picture. Supply and demand are familiar terms to many, but they are usually used in the context of a pa rticular economy. The study of entire economies, however, must deal with the sum total of supply and demand in an economy--in others words, in aggregate. The nominal value of money does not change (A Rs.10 bill is always worth Rs. 10), but the purchasing power of a unit of money is subject to change as prices fluctuate. Interest rates are commonly used as a measure of the cost of borrowing money, and changes in this cost have an important effect on aggregate demand in an economy

Identification: Aggregate demand (AD) is a macroeconomic term referring to the total goods and services in an economy at a particular price level. Plotting these two on a graph produces what's called an aggregate demand curve, reflecting the fact that prices and demand are subject to change. The AD curve has a downward slope because as prices rise, demand for goods and services decreases. Interest rates represent the cost of money, and therefore have an effect on prices and aggregate demand. Features : The standard equation for aggregate demand is: AD = C + I + G + (X-M), where C is consumer  expenditures on goods and services, I is capital investment, G is government spending, X is total exports, and M is total imports. The quantity (X-M) provides a figure for net exports. Taken together, these factors constitute the total demand for the gross domestic product of an economy. Effects: A change in aggregate expenditures on real production, especially those made by the household and business sectors, that results because a change in the price level a lters the interest rate which then affects the cost of borrowing. This is one of three effects underlying the negative slope of the aggregate demand curve associated with a movement along the aggregate demand curve and a change in aggregate expenditures. The other two a re real-balance effect and net-export effect. The interest-rate effect is one of three basic effects that indicates why aggregate are inversely related to the price level. The interest-rate effect works like this: A higher price level induces an increase in the interest rate which results in a decrease in borrowing used for consumption expenditures and investment expenditures. A lower price level has the opposite affect, inducing a decrease in the interest rate which triggers an increase in borrowing used for consumption expenditures and investment expenditures. Before examining the details of the interest-rate effect, consider the specifics of what it does. A typical aggregate is presented in the exhibit below. The negative slope of the aggregate demand curve captures the inverse relation between the price level and aggregate expenditures on real production.

When the price level changes, the interest-rate effect is activated, which is what then results in a change in aggregate expenditures and the movement long the aggregate demand curve. Most investment expenditures by the business sector and a fair amount of consumption expenditures by the household sector (especially for durable goods) are made with borrowed funds. Businesses typically borrow the funds needed for capital goods like factories and equipment. Households often borrow the funds used to buy durable goods like cars and furniture. The cost of borrowing these funds depends on the interest rate. A higher interest rate can add to the overall cost of the expenditure. A lower interest rate can reduce the overall cost of the expenditure. This means that changes in the interest rate can have a big impact on consumption and investment spending. The interest rate tends to increase and decrease as the price level increases and decreases. This means that a higher price level induces a higher interest rate which raises the cost of borrowing and discourages investment and consumption spending. A lower price level has the opposite result.

Suppose, for example, that Ragesh Nair is primed and ready to buy a brand new Hyundai, i 20. Because this purchase will set him back over Rs. 700000 which exceeds his available bank account balance, he plans to borrow the necessary funds. A four-year loan with a 10 p ercent interest rate would result in monthly payments of Rs.17766, an expense he can handle. However, a boost in the price level that increases the interest rate on this loan to 12 percent results in monthly payments of Rs.18435. This extra Rs.669 causes Ragesh to pause and rethink this planned purchase. If he decides the extra expense is too much, then he has fallen victim to the interest-rate effect. Make note of the different role that interest rates play in a change in aggregate demand (a shift of the aggregate demand curve) and a change in aggregate expenditures (a movement along the aggregate demand curve). When interest rates change as a result of changes in the price level, the result is a change in aggregate expenditures and a movement along the aggregate demand curve. This is, in fact, the interest-rate effect. If interest rates change for any other reason (and there are many), the result is a change in aggregate demand and a shift of the aggregate demand curve. In this case, interest rates are an aggregate demand determinant. Significance: The impact of interest rates on aggregate demand is the reason why controlling the interest rate is a powerful tool in monetary policy. This says that as price increases, interest rates will increase causing investments to decrease. If prices are higher, then people will have less money because they will be forced to spend more. If interest rates are higher, people will be less willing to put what little money they have into investments. Since Investments are part of the aggregate demand, the quantity of aggregate expenditures will go down, showing a negative relationship between price and aggregate expenditures.

How does Interest Rates affect Inflation: Inflation is the rise over time in the prices of goods and services. It's usually measured as an annual percentage, just like interest rates. Most people automatically think of inflation as a bad thing, but that's not necessarily the case. Inflation is the natural byproduct of a robust, growing economy. No inflation, or deflation (the lowering of prices), is actually a much worse economic indicator. Also, in a healthy economy, wages rise at the same rate as prices.

A standard explanation for the cause of inflation is "too much money chasing too few goods". This is also called the demand-pull theory. Here's how it works:

1. For several possible reasons, more money is being spent than normal. This could be because interest rates are low and people are borrowing more. Or perhaps the government is spending a lot on defense contracts during a war. 2. There's not enough supply to keep up with the rising demand for homes, cars, tanks, missiles, etc. Manufacturers are producing goods at a slower rate than people are de manding goods. 3. When supply is less than demand, prices go up. Another explanation for inflation is the cost-push theory. Here's how that works: 1. For several possible reasons, the cost of doing business starts to go up independent of  demand. This could be because labor unions negotiated a new contract for h igher wages, the local currency loses value and the cost of exporting foreign goods goes up, or new taxes have put a strain on the bottom line. 2. It's called cost-push inflation because the rise in the cost of doing business pushes the price of  products up.

So how do interest rates affect the rise and fall of inflation? Lower interest rates put more borrowing power in the hands of consumers. And when consumers spend more, the economy grows, naturally creating inflation. If the Govt. decides that the e conomy is growing too fast-that demand will greatly outpace supply-then it can raise interest rates, slowing the amount of  cash entering the economy. It's the Govt’s responsibility to closely monitor inflation indicators like the Consumer Price Index (CPI) and the Wholesale Price Indexes (WPI) and do its best to keep the e conomy in balance. There must be enough economic growth to keep wages up and unemployment low, but not too much growth that it leads to dangerously high inflation. The target inflation rate is somewhere between two and three percent per  year.

Impacts of Interest Rates on Indian Economy and Economic growth: Interest Rates and the Economy: The economy is a living, breathing, deeply interconnected system. When the RBI changes the interest rates at which banks borrow money, those changes get passed on to the rest of the economy. For example, if the RBI lowers the funds rate, then banks can borrow money for less. In turn, they can lower the interest rates they charge to individual borrowers, making their loans more attractive and competitive. If an individual was thinking about buying a home or a car, and the interest rates suddenly go down, he or she might decide to take out a loan and spend, spend, spend! The more consumers spend, the more the economy grows.

The more money consumers spend, the better the economy is.

That's why the stock market tends to go up when the RBI lowers interest rates, or even hints at thoughts of lowering interest rates. It's a sign to investors that people will be buying more goods and services and those companies will ramp up production and create more jobs. Lower rates are doubly good for the stock market, because if the funds rate goes down, then bonds and other fixed-rate securities won't pay as much as other, slightly riskier investments like the stock market. The influx of investor money into the stock market will in turn raise stock prices, another indicator of a healthy economy. A lower funds rate also decreases the value of the Rupee on the foreign exchange market. While a longterm drop in the value of the Rupee is bad news for the economy as a whole, it can be good short-term news for domestic manufacturers. When the Rupee goes down, it becomes more expensive to buy goods and services from foreign companies. This encourages companies to buy domestic products, injecting more cash into the economy. Because the RBI’s monetary policy decisions have such a powerful influence on the strength and direction of the economy, banks, lenders, borrowers and investors spend a lot of energy analyzing the RBI’s every move and word. If the RBI hints that it will raise interest rates to combat inflation , the banks might be worried that the RBI knows something they don't, na mely that inflation is on the rise. As we discussed earlier, inflation affects the real interest that a lender earns on a loan. To adjust for the possibility of rising inflation, banks might raise their long-term interest rates. Gross Domestic Product : The gross domestic product (GDP) - The output of goods and services produced by labor and property located in the India - is the most important economic indicator published. A larger-than-expected quarterly increase or increasing trend is considered inflationary, causing concern the Govt might need to intervene and raise interest rates in order to slow growth. Conversely, a negative growth, or economic downturn may cause the Govt to lower interest rates to stimulate the economy and increase the growth rate.

Factors leading to change in Interest rates: Causes of Interest Rates: Following are the major causes of interest rate changes; Deferred consumption Inflationary expectations Alternative investments Risks of investment Liquidity preference Taxes • • • • • •

Deferred consumption : When money is loaned the lender delays spending the money on consumer goods, since according to time preference theory people choose goods now to goods later, in a free market there will be a positive interest rate. Inflationary expectations: Most economies generally show inflation, it means a given amount of money buys fewer goods in the future than it will now. The borrower needs to compensate the lender for this. It means if the economy indicates any sign of inflation the possibility of increase in interest rates will be more. Alternative investments :

The lender has a choice between using his money in different investments. If he chooses one, he misses the returns from all the others. Different investments effectively compete for funds. Risks of investment: There is always a risk that the borrower will go bankrupt or otherwise default on the loan. This means that a lender generally charges a risk premium to make sure that, across his investments; he is compensated for those that fail. Liquidity preference : People prefer to have their resources available in a form that can immediately be exchanged, rather than a form that takes time or money to realize. Taxes: Because some of the gains from interest may be subject to taxes, the lender may be firm on a higher rate to make up for this loss.

Impact on other variables with Increa se/ decrease in interest  rates(stock exchange, pvt . investment, exchange rate, consumption ): Impact of Interest Rate changes in the Stock Market: Why do interest rates have such a big impact on the stock market? There is always an inverse relationship between the interest rates and stock market. Generally if the interest rates are going high the stock market will fall and vice versa. There are a number of reasons why the inverse relationship between interest rates and stock prices holds. The three main ones are associated with the impact rates have on; • • •

Macroeconomic conditions Attractiveness of equity as an Asset Class Cost of transacting.

Macroeconomic Conditions: Low interest rates are good for business, it makes it cheaper to borrow funds, invest in new projects, expand supply, etc. Low interest rates also increases consumption as debt finance becomes cheaper and people’s disposable income rises as existing interest payments are reduced. A decrease in interest rates therefore increases revenue expectations for most businesses. Assuming a relatively gentle inflationary environment, this increases expected earnings, pushing up company valuations and stock prices. Of  course an increase in rates has the opposite effect by reducing earnings expectations and pushing stock prices downwards. Asset attractiveness: An increase in interest rates makes equity relatively less attractive as an asset class because the risk-free return available elsewhere increase. When there is an increase in interest rates the interest on deposit

also will increase. It will make the equities less attractive. As interest rates go up, new issues of  government securities are made at a higher premium rate. This means that the risk premium associated with the stock market, the reward for taking the extra risk of buying equity, declines. Cost of transacting: Much of the volume in the markets these days, whether retail or institutional, is made ‘on margin’. This means that initially the investor only has to put up a small portion of the funds needed to buy shares and the remaining funds are loaned by the broker on a short term basis. An increase in interest rates increases the cost of margin trading. As the cost of trading increases, marginal profit opportunities begin to look less attractive and as a result demand volume is reduced and the price of shares falls. On the other hand a reduction in rates makes margin trading more affordable, increases the number of buyers in the market and pushes the price up. If a banks are paying as high as ten per cent in interest for cash deposit annually, lots of people will prefer  to deposit their money in that bank than investing in the stocks as well as mutual funds this will affect the stock market very badly.

IMPACT ON PVT . INVESTMENT: Private investment is an increase in the capital stock such as buying a factory or machine. (Investment in this context does not relate to saving money in a bank.) When firms and individuals decide how much investment to make interest rates and marginal efficiency of  capital are important. Interest Rates If interest rates are high then it makes it expensive to borrow money. This will deter investment because investment is often financed through borrowing. Also when interest rates are high it makes it more attractive to save money. Investment is often financed out of retained profit. High interest rates mean that investment is relatively less attractive than saving money in a bank.

Also To invest many firms will, like people, have to borrow. They will borrow if they think that the rate of  return on their investment is greater than interest rates. If interest rates rise then fewer investment projects are likely to be viable, because with the higher cost of borrowing they are now less profitable. The rise in interest rates will therefore reduce the level of investment. The amount investment falls by depends on the interest elasticity of demand for investment. •

Assuming inflation is zero, and interest rates are 3%. Then any investment project would need an expected rate of return of at least greater than 3%. If interest rates were 6%, then any investment project would need an expected rate of return of at least greater than 6%, and therefore less investment would occur.

The Marginal efficiency of Capital The marginal efficiency of capital refers to how much investing in capital increases output. Specifically it refers to the annual percentage yield earned by the last additional unit of capital. •

•

If the marginal efficiency of capital was 5% and interest rates were 4%, then it is worth borrowing at 4% to get an expected increase in output of 5%. However, if the marginal efficiency of capital is less than interest rates it is not worth investing.

IMPACT ON EXCHANGE RATES: Currency exchange rates are determined everyday in large global currency exchange markets. There is no fixed value for any of the major currency -- all currency values are described in relation to another  currency. The relationship between interest rates, and other domestic monetary policies, and currency exchange rates is complex, but at the core it is all about supply and demand. 

Interest rates influence the return or yield on bonds. Because, for example, RBI Treasury bonds can only be bought in Rupee, a high interest rate in India will create demand for Rupee in which to purchase those bonds. A low interest rate, relative to other major economies, will reduce demand for Rupee, as 

investors move toward higher yielding investments. At least, this is true in normal periods of economic expansion. The relationship becomes a bit inverted, however, when investors become highly risk averse. In periods of credit contraction or recession, money will tend to move into safer assets, driving down interest rates. The low yield on bonds then is a reflection of the demand for their relative safety and low credit risk, and not a deterrent. In Interest rates can also have economic effects, which influence currency exchange. Following the idea of supply and demand, speculators favor the currency of economies that are expanding, creating a virtual cycle of appreciation. An economy who's GDP is rising faster than its monetary base is by default increasing the value of its currency, and this will likely be reflected in currency exchanges. 

IMPACT ON CONSUMPTION: Consumption will fall when interest rates are raised. This happens for two reasons. The first is that it is now more expensive to borrow money. This will put people off borrowing, and lower borrowing means lower spending. However, it is not just new borrowing that is affected, but also people who are still paying off existing borrowing. For many people their main investment is their house. To buy this they are quite likely to have taken out a mortgage and higher interest rates means higher mortgage payments. These reduce their disposable income and so leave them with less money each month to spend. The same will be true for people who have bo rrowed to buy other things as well. Also a rise in interest rates increases the profitability of saving (substitution effect). It could also be argued that the interest rate level is an indicator of household expectations concerning their own financial situation and domestic economic developments. Experience shows that an increase in interest rates coincided with lower expectations, heightened caution and lower consumption. MAJOR SECTORS AFFECTED: Change interest rates will have a major impact on two sectors such as; • •

Automobile Real Estate

Automobile: Increase or decrease in interest rate will directly affect the automobile industry because a majority of  people are depending on car loans or two wheeler loans for buying vehicle. So if the interest rates are increasing, people won’t be able to afford this and normally the demand for automobiles will come down this will have a very bad impact on the industry. Real Estate: Real estate industry is closely related to the interest rates. A small change in the interest rate can influence the performance of the industry. If there is an increase in interest rate the demand for real estate will come down because a large portion of real estate investors are taking the support of  bank loans for investment. Normally if the interest rate goes up they won’t be able to take a loan and invest. This will lead to the negative growth of the industry. If the interest rate in decreasing, it will help to boost the industry’s performance.

References: •

http://www.rbi.org.in/ 

•

www.mospi.nic.in

•

www.indiabudget.nic.in.

•

http://www.ehow.com/about_5125402_interest-rate-effect-aggregate-demand.html 

•

http://findarticles.com/p/articles/mi_qa5462/is_200103/ai_n21470239/ 

•

http://www.bis.org/ 

•

http://www.economywatch.com/indianeconomy/indian-economy-overview.html 

•

http://www.morganstanley.com/views/gef/index.html 

•

http://economics.about.com/cs/taxpolicy/a/taxing_growth.htm

•

http://www.moneymadeclear.org .

•

http://www.businessworld.in/index.php/Interviews/Businessmen-Overemphasise.html 

•

http://www.referenceforbusiness.com/small/Inc-Mail/Interest-Rates.html