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India cuts main interest rate to 8% to
help lift growth
India has cut its main interest rate for the first time in three
years in a move that may signal a shift in focus to growth
from inflation.
The Reserve Bank of India (RBI) lowered its key rate to 8% from
8.5%.
Analysts had expected a smaller, quarter of a percentage point
rate cut.
However the central bank, which had increased interest rates 13
times since March 2010, said that growth was now at levels that
warranted a bigger intervention.
Especially as India's domestic and foreign business environment
was not improving as quickly as many people had hoped following
the global economic crisis, and was being hamstrung by continuing
problems in the eurozone.
The reduction in the interest rate "is based on an assessment of
growth having slowed below its post-crisis trend rate," said RBI
governor Duvvuri Subbarao.
According to the latest figures, India's gross domestic product
expanded by 6.1% between October and December, from a year
earlier, the weakest pace of growth in almost three years.
http://www.bbc.co.uk/news/business-­‐17737772 Decrease Of Interest Rate In India The significant issue in the text above is that the central bank of India must lower their interest rate from 8.5% to 8% due to the financial crisis in Europe that have affected both their local and foreign market. In order to stabilize the economy, India has to shift the aggregate demand curve (AD) to the right. Shifting AD to the right, from AD to AD 1 symbolizes the increase of gross domestic product (GDP), which means increasing the total amount of goods and services produced in the economy in a year. Aggregate demand can be defined as the total spending on goods and services in the economy at every given price. This action is a part of expansionary monetary policy. It can be defined as a policy that is focused on increasing the money supply in a country to stimulate the economy. The situation can be represented through an aggregate demand-­‐
aggregate supply diagram, diagram 1. Short-­‐run aggregate supply (SRAS) curve is a line that represent the total goods and services produced by firms at a given price level. Another line that should be added on diagram 1 is the long-­‐run aggregate supply (LRAS) curve, which shows the potential GDP, when all goods and services are efficiently utilized. Another diagram that can also express India’s situation is the “trade cycle” (diagram 2), where LRAS stands for the potential GDP line (Yp). Also LRAS can be presented through a “production possibility frontier (PPF)” model (diagram 3). At the moment India is at its down swing, which means that LRAS is positioned on the right of its equilibrium (Ye < Yp).1 Diagram 1 Diagram 2 Diagram 3 Why will AD shift to the right by lowering interest rates? This is because the increase of income the economy will gain from it. For example: firstly, people will be more interested in borrowing money because they will be charged less, secondly, people are willing to invest more, thirdly, bonds will be sold out faster due to the lower interest rate etc. Through this, government will have more money to spend in the economy. In order to increase GDP as fast as possible, government will create more jobs to reduce unemployment rate so more goods and services will be produces in a certain period of time. Base on the neo-­‐classical perspective, they believe that a market will clear by itself, which means that although AD and SRAS shift, they will automatically shift back to LRAS but with higher price level. When AD shifts to the right, there will be an increase in the real output value and also the price level, from P to P1. In order to produce the amount of output, firms will have to pay the workers their overtime wages. Due to the equilibrium point before, which means that all resources are fully utilized and no unemployment rate, they will have to increase the price level while waiting for the resources. It is called “bottle-­‐neck”. By increasing the price level SRAS will shift to the left, which creates an even higher price level. This can be shown in diagram 4. Diagram 4 On the other hand, in Keynesian’s perspective, a market can’t clear by itself. Keynesians believe that by shifting AD to the right, while increasing the amount of real output, there will not be an increase in average price level. As it is shown in diagram 5 that in a Keynesian model, LRAS curves upwards. This shows that at a certain point the value of real output will not be able to increase, only the average price level will, due to the scarce resources. Diagram 5 Although shifting AD to AD 1 can boost up the economy, there will be a consequence, which is the increase of price level: as it is also shown in diagram 1, where P moves to P1. Additionally by only shifting AD, it will not create a long-­‐
term effect, instead short-­‐term. In order to create a greater effect but in a long period of time, the government has to shift the LRAS instead of AD or SRAS. To shift the LRAS, supply side policy has to be applied. This is used to increase the potential output of the economy by increasing the quantity of factors of production. Cia Hua