This has been taken from our blog,”Brinks of economic thoughts.”
[This had been written when Raghuram Rajan was appointed the RBI governor.
Last year we saw many issues which came up during the time when he left the job at RBI.
Given a fact that he has had immense contribution to the economy and we as a student respect him with high regards.]
We know that central banks follow a policy of minimising inflation level,,,so wee did see many times in past 5 years,,that RBI did prefer hiking rates to control excess liquidity in the market,,sucking liquidity ,,thus making its efforts to contain inflation.
Even during when newly appointed governor of RBI raguram rajan,,there was lots of hype that RBI may now prefer easing prime rates,,,but even he did prefer containing inflation as his prime target,,
The link between the real interest rate and nominal interest rate is provided by the famous Fisher equation which postulates that the nominal interest rate is the sum total of a real interest rate and expected inflation.5 One implication of this is that the nominal interest rates should move in tandem with inflation. In the real world, nominal interest rates may not change one for one with the inflation rate but the direction more often is similar. Countries with higher inflation tend to have higher nominal interest rates than countries with lower inflation. Accordingly, the nominal interest rates in advanced countries tend to be lower than in emerging market and developing countries.
- A central bank can influence real interest rates through financial repression/reforms and lagged monetary policy response to inflation. Real interest rate is a real phenomenon, but it could change in the short-run depending on how monetary policy responds to inflation and inflation expectations.
- For the determination of growth and investment at the macroeconomic level the real interest rate is more relevant, even though the nominal interest rate is important for investment planning at the firm level.
In the last 10-year period from 2003-04 to 2012-13, monetary policy response can be broadly categorised into four phases based on growth-inflation outcome and the rapidly changing monetary policy response:
Phase I of 5 years of 2003-08 of high growth but rising inflation concern towards the later part of the period when repo rate was raised from 6 per cent to 9 per cent and the cash reserve ratio (CRR) was raised from 4.5 per cent to 9 per cent.
- Phase II of 2 years of 2008-10 following the global financial crisis when the repo rate was reduced from 9 per cent to 5.25 per cent and CRR was reduced from 9 per cent to 5.75 per cent.
- Phase III of 2 years of 2010-12 of monetary tightening responding to rising inflation when policy rate was raised from 5.25 per cent to 8.5 per cent but CRR was reduced to 5.5 per cent.
Phase IV of over a year of monetary easing in 2012-13 and 2013-14 so far with the repo rate reduced to 7.25 per cent and CRR lowered to 4.0 per cent; though since mid-July 2013, the RBI has tightened the monetary and liquidity conditions without changing the policy repo rate and CRR to address exchange market volatility
Harsh Vardhan Pathak