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nterest rate and elementary economics

News Published: Wednesday, Mar 21, 2012

Interest rate and elementary economics

Wednesday March 21 2012
Sandip Kumar Sureka

'The General Theory of Employment, Interest and Money' was published by Keynes in 1936:

the book was one of the founding stones in macroeconomic theory and his recommendations on trouble-shooting the economies in recession still enlighten the policy-makers in designing macroeconomic policies during the pitfalls of the economy. However, the current macroeconomic scene of Bangladesh is somewhat different from the global economic situation of 1930s; the title of the book reminds us of the importance of interest rate in an economy. Interest rate is the most important variable which a monetary authority controls as it has very important implication for short-run fluctuations in the economy.

In recent times interest rate has been an issue of debate among the policy makers, business community and economic observers in Bangladesh. The debate gained momentum when the Bangladesh Bank (BB) announced to take monetary tightening measures to tame inflation in its Monetary Policy Statement (MPS) for January to June of the current fiscal. Proponents of monetary tightening measures say that higher interest rate will reduce growth rate of money supply, thereby will reduce aggregate demand in the economy and, thus, will reduce inflationary pressure. While opponents say that higher interest rate will make business unprofitable and will have an adverse effect on economic growth. In recent times we have seen abolishment of interest rate cap on lending interest rate by BB, then imposition and removal of cap on deposit rate by the Bankers Association of Bangladesh (BAB) and finally reintroduction of interest rate cap on both lending and deposit rates by the Association of Bankers of Bangladesh (ABB). Such developments inspired this writer to have a look at the elementary economic theories to find a justified direction of the interest rate.

The fundamental question we face here is: what is interest rate? Why interest is paid to depositors? Interest is nothing but an incentive for postponing current consumption. As households value current consumption more than the future consumption, in the absence of interest they would not save. Here the real interest rate is what they count. Based on inflationary expectation, households calculate real interest rate and then decides what portion of money they are going to save. Higher interest rate will induce higher savings rate. And savings of households are a source of funds for firms, which they borrow through the financial intermediaries. The difference between lending rate and deposits rate is the interest-rate spread. It depends on the efficiency of the intermediaries and market structure.

If we look at the real interest rate in the recent years, we will see that both lending and deposit rates are on a declining trend and the deposit rate has been negative or close to zero since fiscal year (FY) 05, except for the year FY 09. Negative real interest rate implies that economy is penalising savers for postponing the current consumption. In this case, an informed individual will optimise its utility by consuming the entire amount of current income. S/he may even consume out of his/her savings. When interest rate is negative, one can be better off by holding consumption goods or land instead of deposit in commercial banks. In 2005, an average individual household's 82.8% of total income did go into consumption expenditure while in 2010 the portion of consumption expenditure was 95.8% (Preliminary Report on Household Income & Expenditure Survey-2010). That might be indicative of how households are responding to negative real interest rate.

We can use simple demand-supply framework to explain the impact of interest rate cap on savings, investment and interest. Let us assume interest rate spread is zero, meaning only one interest rate in the economy. We assume that the equilibrium interest rate is 17 per cent. Now if a 15 per cent interest rate cap is imposed, savings will be equal to Q1 amount which is lower than the equilibrium level (Q2). This amount of fund can be lent out at 20 per cent interest rate. Now banks will have an incentive to increase the interest rate up to 20 per cent. If there is an interest rate cap, the banks can charge higher interest rate implicitly by imposing direct or indirect charges. The result is effectively higher financial costs for the borrowers, no matter what the interest rate is.

Even if banks strictly follow the lending rate cap and do not impose additional indirect charges, then they will lend only to those borrowers who have stronger terms with the banks or who are most safe borrowers. From macroeconomic point of view, this is not desirable. This is firstly because it violates equity principle. Secondly, this may work as a barrier to entry for new businesses that are planning to set up a business by borrowing from commercial banks. This kind of barrier to entry can be a major supply-side constraint. It is notable that part of the business community is concerned about the higher interest rate, while the other is concerned about the availability of loans. Possibly, the first portion of the business community consists of those businessmen who have stronger terms with financial institutions and those belonging to the second category have lower chance of getting credit at the capped rate. Interest rate cap also restricts banks to impose a risk premium to risky borrowers. The rates used in the diagram are arbitrary but the implication is not. 

The argument, 'Higher interest rate will increase cost of doing business', may not be a valid one in the current situation. Negative or very low real interest rate will encourage both depositors and borrowers to invest in assets like real estate and land. This kind of investment can push the price of those assets further. Land and real estate are important factors of production and higher price of these assets will lead to higher cost of doing business. So higher price or rent of land may exceed the savings from lower financial cost.

In our current macroeconomic situation, removal of interest rate cap and letting interest rate will make saving more attractive to both domestic households and non-resident Bangladeshis. This will help restore internal as well as external imbalances; thus, it will help increase investment required to achieve our medium term growth targets, which will benefit all the stakeholders.

The writer is a Senior Research Associate at Policy Research Institute of Bangladesh (PRI). E-mail: ssureka@pri-bd.org