Download Learn how depreciating rupee induces interest cut There is lot of

Learn how depreciating rupee induces interest cut
There is lot of expectation from the RBI about a possible cut in key
interest rates in its upcoming policy. While the expectations of rate cut
might be warranted keeping in mind the slowing economy and falling
commodity prices, primarily oil, but we have to remember that there is
another variable besides interest rate which is affecting the monetary
conditions. And that is the Exchange Rate. This article does not try to
predict the timing and extent of the interest rate cut; it only tries to
explain the “other’ variable which affects monetary policy and the
interlinkage and dependence between both of them.
The economy is in equilibrium where the IS-LM curve meet - the
relationship between interest rates and real output in the goods and
services market and the money market. The intersection of the IS and LM
curves is the "general equilibrium" where there is simultaneous
equilibrium in both markets. Now, let us shift focus to the money markets
and transmission of monetary policy on the aggregate demand (or prices or
credit). We have to see which are the factors that affect the “aggregate
demand” or “prices” in the economy.
The most noticeable feature of the aggregate demand curve is that it is
downward sloping. There are a number of reasons for this relationship.
Remember the downward sloping aggregate demand curve means that as the
price level drops, the quantity of output demanded increases. Similarly,
as the price level drops, the national income increases. There are three
basic reasons for the downward sloping aggregate demand curve. These are
Pigou's wealth effect, Keynes' interest-rate effect, and MundellFleming's exchange-rate effect. These three reasons for the downward
sloping aggregate demand curve are distinct, yet they work together.
The first reason for the downward slope of the aggregate demand curve is
Pigou's wealth effect. Don’t forget that the nominal value of money is
fixed, but the real value is dependent upon the price level. This is
because for a given amount of money, a lower price level provides more
purchasing power per unit of currency. When the price level falls,
consumers are wealthier, a condition which induces more consumer
spending. Thus, a drop in the price level induces consumers to spend
more, thereby increasing the aggregate demand.
The second reason for the downward slope of the aggregate demand curve is
Keynes's interestrate effect. Recall that the quantity of money demanded
is dependent upon the price level. That is, a high price level means that
it takes a relatively large amount of currency to make purchases. Thus,
consumers demand large quantities of currency when the price level is
high. When the price level is low, consumers demand a relatively small
amount of currency because it takes a relatively small amount of currency
to make purchases. Thus, consumers keep larger amounts of currency in the
bank. As the amount of currency in banks increases, the supply of loans
increases. As the supply of loans increases, the cost of loans i.e. the
interest rate decreases. Thus, a low price level induces consumers to save,
which in turn drives down the interest rate. A low interest rate
increases the demand for investment as the cost of investment falls with
the interest rate. Thus, a drop in the price level decreases the interest
rate, which increases the demand for investment and thereby increases
aggregate demand.
The third reason for the downward slope of the aggregate demand curve is
Mundell-Fleming's exchange-rate effect. Recall that as the price level
falls the interest rate also tends to fall. When the domestic interest
rate is low relative to interest rates available in foreign countries,
domestic investors tend to invest in foreign countries where return on
investments is higher. As domestic currency flows to foreign countries,
the real exchange rate decreases because the international supply of
dollars increases. A decrease in the real exchange rate has the effect of
increasing net exports because domestic goods and services are relatively
cheaper. Finally, an increase in net exports increases aggregate demand,
as net exports is a component of aggregate demand. Thus, as the price level
drops, interest rates fall, domestic investment in foreign countries
increases, the real exchange rate depreciates, net exports increases, and
aggregate demand increases.
There are two monetary variables which affect aggregate demand (or
somebody can assume credit growth also):
a) Domestic Interest Ratesb) Exchange Rate
We all know that interest rates affect the aggregate demand and result in
a northward or southward shift of the “demand curve” depending on whether
interest rates are increased or decreased. Exchange rate also affects the
“aggregate demand” at the macro level through its effect on the exports,
imports and trade balance. Hence, to find the combined effect of both,
interest rates and exchange rates on aggregate demand, an index needs to
be created whose formula will be somewhat like this:
Wi (Ri - Ro) + We (Et - Eo)
Wherein
t = 0 is the base period and Wi and We are the weights derived from the
estimated coefficients of real interest rate and real exchange rate from
the generalized aggregate demand equation. It is from this equation that
it is derived that in India 58% of aggregate demand change is explained
by interest rates and the remaining 42% from exchange rates. Hence,
interest rates play a bigger role that exchange rates in explaining
aggregate demand. And actually also that should be the case because
exchange rates are also affected by domestic interest rates. It is also
pertinent whether we consider the Real Effective Exchange Rate or the
Nominal Effective Exchange Rate. From the application of this formula it
is derived that a the 10% nominal effective exchange rate depreciation of
the Indian Rupee is equivalent to 100 bps of rate cuts in terms of
impacting monetary conditions.
To conclude, I am not here to speculate whether the RBI will cut rates or
no and when and by what quantum. I just want to state one thing that
while we may expect the RBI to cut rates but we should alongside keep in
mind that a deprecating rupee has in effect resulted in what I call as
the “currency induced interest cut” of a significant magnitude over the
past few months.
- Mehrab Irani
The author is the General Manager - Investments of Tata Investment
Corporation Limited and writes blog called intelligentmoney.blogspot.com.
He may be reached at [email protected]