Interest, Inflation and Money Value

Tuesday, November 10, 2009 10:55:50 AM, Syed Zahid Ahmad

The approach of Reserve Bank of India (RBI) to use ‘interest rate’ as tool to keep inflation under control should be reviewed because interest has not only helped regulating liquidity, but has considerably accumulated Time Deposits and Broad Money in proportion to Gross Domestic Products (GDP) during last 59 years which ultimately cost for sheer loss in money value. The coins of 1 to 20 paise and notes of 1 and 2 rupee are out of circulation in the market. Today 5 rupees coin is used for a purchase which was possible for 50 paise earlier (say in 1970s). So, we may need to use coin of 50 rupees to get a product in 2010’s we had been purchasing for 50 paise in 1970s. How long we will keep minting coins of high denomination to counter the inflation and loss in money value? A day will come when people will not keep hundred rupee notes in their purses and we have to mint currencies in denominations of millions only.

Since inflation is blamed for loss in purchasing power of money it is important to understand how inflation deteriorates the purchasing power of money? Inflation is simply meant for increase in prices of goods and services without any improvement in their quality. Prices of goods and services increases either due to increased money supply without any addition in stocks of goods and services; or due to short of supply (goods and services) as compared to demand. In both cases, the buyers intend to pay more for same grade of goods and services, thus money loss its purchasing power.

Since money is not a sellable commodity but a source to measure prices of all goods and services, it is easy to find inflation rate but difficult to measure fall in money value. Though money is considered as capital, there is no system of calculating depreciation of money like other capitals. Considering the fact that the purchasing power of money deteriorates if proportion of total money stock with that of GDP increases, we can measure the decline in money value if we calculate the difference in proportion of money to that of GDP at Market prices. Thus we may say that money value in India has fallen by 3.17 points (from 3.29 points in 1950-51 to 0.12 points in 2008-09) in 59 years.

RBI failed to protect the money value. The broad money as percentage to GDP at market prices has increased multifold (from 23.32% in year 1950-51 to 89.52% in 2008-09). This increase in broad money in proportion to GDP is due to increase in share of time deposits in Broad Money from 14.07% in 1950-51 to 73.69% in 2008-09. Considerably almost half (47%) of Time deposits (Rs. 35,10,385 Crores) in 2008-09 is equal to total paid interest (Rs. 16,48,822 Crores) over time deposits during 1950-51 to 2008-09. Once interest is accrued into time deposit, it cannot be separated from broad money which ultimately increases. People hold and spend more money to buy same goods and services if GDP increases lesser than the ratio interest is accrued into the monetary system. It leads to sheer devaluation of money.

While it is argued that interest compensates the loss in money value due to inflation; it is prudent that interest further inflates the economy by deteriorating the money value instead of compensating loss in money value. Considering the minimum rate of interest payable in different years, at least Rs. 16,48,822 crores has been paid as interest over Time Deposits during 1950-51 to 2008-09. This amounts about half (47%) of outstanding Total Time Deposits in 2008-09. Similarly the interest received against bank credits during this period was Rs. 18,43,154 which is 38.69% of Broad money in 2008-09. The total interest paid on Time Deposits and interest received against Bank Credits is about 73.30% of Broad Money in 2008-09. Since accrued interest on deposits increases the stock of money in the economy, the broad money in proportion to GDP increases and the difference in GDP and Broad money as percentage to broad money declines. It leads to cause inflation and fall in purchasing power of money.

The percentage share of interest over time deposits to GDP has increased from 0.20% in 1950-51 to 5.00% in 2008-09. Only interest on time deposits has increased the market prices by 5% in 2008-09, whose impact was negligible in 1950-51. The total interest as percentage to GDP has increased from 0.58% to 10.75%. Similarly Total interest as percentage to broad money has increased from 2.47% in 1950-51 to 12.64% in 2008-09. Monetary policy to regulate money supply should be based on estimates of national income and expenditure. It is required that the RBI should regulate money supply according to growth in national income and expenditure instead of wish to keep inflation at desired rate and to achieve targeted saving and credit growth rates. Since major inflationary factors are disbursement of interest over deposits, rigid policies to regulate supply of commodities, fiscal deficits and debt finances we need sound monetary policy considering all these aspects while regulating money supply. Otherwise the actual rate of inflation may vary from the estimated rate of inflation based on projecting the growth in price indices in wholesale and retail markets.

While the rigid supply policies of agricultural produces create shortage of supply in the market, interest on deposits increases the supply of money, empowering the purchasing powers of potential buyers and ultimately increasing the price levels. Interest inflates the economy by two ways. Interest over credits is charged before the output is sold in the market, so the cost of credit increases the price of the output. On the other hand, since depositors get interest over deposits irrespective of sale of produced goods and services in the market, it inflates the price levels with empowered purchasing powers of potential buyers. So interest has both demand and supply side effect on inflation.

RBI can’t protect the economy from inflation as it failed to protect the value of currency minted by her? RBI can’t regulate supply policy of essential goods which is creating shortage of essential items in the market, thus inflating their prices. RBI is supposed to just regulate the banks according to the Banking Regulation Act 1949, which compels the banks to give interest on deposits and charge interest over credits. Since 1951 the value of interest money in India is more than 73.30% of Broad Money in 2008-09. Just to induce bank deposits or arranging debt finance, we are inviting inflation and losing the purchasing power of money. If no bank will offer interest on deposits, would all customers withdraw their deposits? Don’t people feel safety of funds in banks? Does interest is only means to induce depositors? There had been a time when there were hardly any avenues for non debt investments, but now after globalization and liberalization there are many other alternatives to induce potential depositors. Growing business of equity based investments may induce the banks to start small level equity based banking to finance small enterprises working in agriculture and industry sector.

If we want anti inflationary economic growth, besides adopting a banking mechanism where money can’t be accumulated unless the existing money stock acts to add value in output of goods and services, we have to review and change the regulatory policies on supply of essential commodities. All public finances should be made through either revenue receipts or by equity finances. Then we would be able to avert inflation, otherwise money will loose its purchasing power. RBI should not be just conscious about stability in the rate of inflation by adjusting the interest rate, but should aim to protect the money value by restricting the growth of money within GDP growth rate.

To get anti inflationary monetary system we may need to amend our Banking Regulation Act 1949 and stop making debt financing. RBI can’t allow interest-free banking unless the banking regulation act 1949 gets amended by the Parliament. Hope RBI will suggest the government that inflation is caused due to strict supply policies and interest based banking, and it can’t be restored through interest itself, therefore the Government besides relaxing regulatory policy on essential commodities should amend the banking regulation act 1949 to permit interest free (equity based) or participatory banking in India and issue non debt securities to meet deficit finance. It is just possible to do equity business of smaller level through banks and market equity based securities and corporate bonds through stock markets so that both the markets have their own set of clientele. Had India made the required changes earlier; we would have saved our economy from inflation and sheer loss in purchasing power of money.

Syed Zahid Ahmad is Asst. Secretary General of All India Council of Muslim Economic Upliftment Ltd. Trust (AICMEU) Mumbai. He can be reached at aicmeu@yahoo.com.

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