Page 189 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes

Task Find out the changes in marketing efforts made by some major companies during
the high inflation situation in the 2008-2009.

Inflation and Interest Rate

Interest rates are, to a large extent, a function of the level of inflation. Higher inflation translates
into a higher expected real rate of return, which in turn translates into a higher level of interest
rates in the economy. The actual impact on interest rates is far from clear. On the one hand,
increased government borrowings and shift in financing from foreign to domestic borrowings
is likely to make interest rates dearer, while on the other hand, higher liquidity with banks, a
phased reduction in CRR and lackluster industrial demand is likely to exert a downward pressure
on interest rates. We are, therefore, likely to see a steeply upward sloping yield curve in the
weeks to come.

1. At the current level of spreads, External Commercial Borrowings (ECBs) have almost
become unviable, forcing companies to come back to domestic FI’s to repay the ECBs they
had raised in 1993-94.

2. The risk insurance premium levied by the export credit agencies, and in all cost of these
borrowings is higher than that of domestic funds.
Higher interest rates also emanate from the inefficiencies of the banking system. The spreads in
banking need to be large enough to accommodate the inefficiencies in banking operations and
their high ratio of operating costs of income. The lack of sufficient downward flexibility in the
real leading rate systems stems from the stickiness of the spreads in the banking sector.
Inefficiencies in the banking system, in turn, affect the working of the Indian corporate sector.

Inflation, Interest Rates and Savings

High real interest expectations cause higher savings. Smaller savings imply higher investment
in the productive sector and so higher the real interest rate, greater is the opportunity cost of
investing. Inflation causes nominal interest rates to go up and thus there is a diversion of funds
towards financial savings taking away a sizeable chunk from the productive sector.
Higher interest rates triggered by high and increasing inflation also lead to the erosion of
market sentiments leading to flight of funds from the financial markets. This is further enunciated
by the fact that the Flls in the last year have withdrawn funds to the tune of $550 million from the
capital markets. The variability of inflation in India has encouraged a diversion of resources to
assets, which provide a hedge against inflation. Thus, savings are diverted in to real estate and
less funds are available for investment in the business sector. Thus in India, the investment in
non productive assets increased, the result of which was eminent in the great price surge of real
estates in the mid-nineties.

Inflation, Exchange Rate and BOP

A high inflation leads to depreciation in the real effective exchange rate and the consequent rise
in the forward premium that exerts a downward pressure on the domestic currency. Although a
falling currency is a positive booster for exports and thus a positive BOP situation, yet the fact
that the currencies in the neighbouring states have fallen at a greater rate has offset this advantage
for India. On the contrary, the debt servicing at a greater rate has offset this advantage for India
since its debt servicing ratio is on the higher side at 22% of the net outflow. Higher interest rates

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