Rate cut spurs economic growth?

B. Venkatesh

THE Reserve Bank of India, like many other central banks, has cut interest rate this year.

There are two schools of thought on the implications of such rate cut on the economy. What are they?

One school of thought is that the rate cut will spur economic growth. When central bank cuts interest rate, most commercial banks follow up with a lending rate cut. This makes borrowing cheaper for businesses and households.

Now, cheaper loans are expected to induce people to spend more on houses and household appliances. Cheaper loans also lure businesses to set up new projects, which may be unprofitable at high interest rates. All these economic decisions are expected to spur the nation's growth.

The other school of thought, however, argues that rate cuts may not be very effective at this point in time. The reason?

Lower lending rates will prompt banks to cut their deposit rates as well, as they need to sustain their profitability levels. Since bank deposit rates act as a benchmark for other deposit rates, our earnings from other savings avenue will also come down. And this will actually reduce consumption, so the argument goes.

Suppose you want to set aside money to buy a car two years hence at Rs 5,00,000, you will have to invest Rs 3,98,500 if the current 2-year rate is 12 per cent. But what if the rate comes down to 10 per cent? You will need to invest Rs 4,13,300 instead.

You will be, thus, required to save more to purchase the goods in future at today's prices. And if your income does not increase, higher savings is required, which will mean a cut in your current consumption.

Then, as job losses in the economy increase, people are likely to save more and cut their current consumption. This way, they will able to live on their savings during the time they are out of job.

The arguments of both schools of thought appear logical and only time will tell which one is right.