Interest Rate and Its Impact on Economy

By Raghunath Pradhan l

Interest is the price paid for the hired capital. Whenever we talk about interest, it is nominal/gross interest not real interest. Nominal interest rate is the rate advertised by a bank. Gross interest rate payable to the depositor is subject to TDS and it does consider the inflation rate as well. Real interest is the TDS as well as inflation rate adjusted rate. So, there may be a case of negative real interest as well which will not attract the savers.

Very few depositors take a note of above concept. Most of them use to invest their hard earned money to deposit with a bank due lack of entrepreneur skill or their business in their other activities or to meet future uncertainties. However, it is  true that people start to deposit or increased their volume of deposit at the time of increased interest rate even sacrificing their present consumption. Likewise, borrowers borrow the money keeping view on the prevalent interest rate. They use to borrow higher amount whenever interest rate is decreasing and vice versa. Interest is also component of cost of production. So, it will be beneficial to raise the loan and start or expand the business when the rate is decreased.

Banks use to pay higher rate to their depositor whenever there is demand from the borrower and vice versa. Banks used to collect additional deposit whenever there is demand even raising the deposit rate. Because, the main purpose of collecting the deposit is to lend.

Depositors and borrowers are the pressure group on determination of interest rate. Institutional depositors deposit heavy amount in the bank. Their deposit play significant role on the total deposit of a bank. So, they are in position to pressure a bank for higher interest. But, institutional deposit is very risky to a bank. Withdrawal from a single institutional depositor may affect the CD Ratio of the bank. Individual depositors deposit small amount out of their savings. They are not organized and not in a position to pressure a bank for higher interest rate. But, individual deposit helps lot to bank for increasing their deposit base. On the strength of individual deposit bank may take their investment decision easily.  

Like depositor, borrowers are also of two types – Retail Borrowers and Corporate Borrowers. Corporate borrowers raise heavy borrowings. So, they are in position to keep the banks under their pressure to reduce the rate of interest. They are the pressure group to the banks because they are organized and in a position to place their collective voice before the authority. Here, it is notable that interest does not constitute significant weightage on their cost of production in most of the cases and really notable thing is Marginal Efficiency of Capital i.e. productivity of the capital. That means if the business environment is conducive despite of increased interest rate total demand of credit may not reduce.

Banks collect the deposit from the savers and lend to the needy person. The difference between interest paid to the depositor and interest charged to the borrowers is called interest margin which is the major source of income of a bank. For protecting the interest of depositor and banking system as a whole, the regulator has introduced the concept of interest spread, base rate, risk based pricing on lending and many more.

The average difference between deposit rate and lending rate is termed as interest spread and as per the regulatory provision it shall not be more than 4.4 in case of ‘A’ class financial institution i.e banks. The rate so computed shall be published on the website of the bank. The basic concept of interest spread is to boost up the general efficiency of the financial institutions prohibiting to charge interest maintaining high amount of spread. Banks efficiency on mobilizing its resources plays vital role on the development of the economy as a whole.

Normally, interest rate is determined by demand and supply of money. Supply and demand of money in their turns are influenced by variety of market forces and economic condition of the country. When interest rates are rising, both businesses and consumers will cut down their spending. It will increase borrowing cost and lead to increase general price level. People will start saving curtailing their investment on real estate and on share market. On the other hand, when interest rates decreases, both business community and general people start to increase spending. People divert their savings into real estate and share market and even on speculative business.

There is inverse relationship between interest rate  and growth & inflation. Whenever interest rate decreases spending from the part of business community and general people increases which assist in achieving high growth and it also tends to increase inflation. Moreover, it also deplete the reserve of foreign currency increasing the import level of the country.  (The author is a former banker, who had served in commercials banks for over three 35 years)