Policy rate primer

Published May 17, 2021
The writer teaches economics and development at SZABIST, Islamabad.
The writer teaches economics and development at SZABIST, Islamabad.

LET’S say, I am a fruit vendor, and the only one in the village. There is only one kilogramme of apples left in my shop. I am about to go home. A person comes to my shop and I sell the apples for Rs100.

The next day something weird happens. A smuggler’s briefcase splits open, and money starts dropping to the ground from his plane all over the village. It’s evening again, and again I am left with just 1kg — but today, there are many buyers. I sell the apples for Rs200.

Here, apples are the total production. The money that the buyer had in the first instance, Rs100, is the money supply. When you increase the money supply — notes falling from the plane — it leads to higher prices, because of higher demand. Economists call this inflation. Note that the total number of apples — GDP or production — does not increase.

One of the better known instruments for dropping money from the plane is lowering the policy rate. Simply put, it is the benchmark rate set by the central bank at which loans would be given. When this is lower, the commercial banks also charge a lower rate for lending.

Economic activity generated by a lower policy rate may be illusory.

Thus, if you wanted to buy a bike, but the bank was charging an interest rate of 20 per cent. You might have been dismayed. But then the benchmark — policy — rate falls to, say, 2pc. You rush to the bank and borrow money to get the bike.

But here is the catch. When you reach the bike company, they tell you that the price of the bike has increased significantly. You ask why. They tell you there are so many people who want a bike now, and they have limited bikes. The prices go up.

Thus, a fall in policy rate leads to increased prices. It does notmake people richer. People have more money, but the goods became more expensive too.

Governments, businesses, and the ‘more patriotic’ economists, almost always support a lower policy rate. They want ‘indigenous’ growth, instead of borrowing from external sources or relying on foreign investment.

Lowering the policy rate can indeed lead to growth in the short run, as they argue. If the economy is in recession, there is idle capacity in the factories. When you lower the policy rate, not only does the demand increase, but also the production. The factories will utilise their idle capacity and make more bikes to catch up with the increased demand. More people want bikes, but there are also more bikes now. Welfare increases.

But in an overheated economy, with high consumption and inflation, and no idle capacity in the factories, the opposite is true. Lowering the policy rate, does not result in more production — as factories are working to their maximum potential already — it results in greater inflation. Having more money, more people want a bike, but the factories have already reached their limit.

Thus, the economic activity generated by the lower policy rate may be illusory, translating to higher inflation, rather than higher production. Perhaps all spells of hyperinflation in history began because governments myopically kept raising the money supply in the hope of more and more growth.

Also, demand-side decisions are simpler. A lower policy rate almost automatically leads to increased demand. But supply-side decisions are complex. Investors and businesses will likely not invest in a bad policy environment or during hard times such as a pandemic. Thus, a lower policy rate may translate into more demand but not a higher aggregate supply.

The point here is not to advocate a higher or a lower policy rate, but to advise caution. Beware of a person — an economist, a journalist or business tycoon — who comes on television to declare an exact figure for the policy rate off the cuff.

The State Bank did a decent job in stabilising the economy, res­toring confidence, stea­d­ying the rupee, and bringing down core inflation. Had Covid-19 not struck, the budget for fiscal year 2020-2021 would have been expansionary. The PTI could well have showcased growth.

But things did not go as planned, and the government wanted to do something rather quick. The high food inflation right now is perhaps a consequence of the authorities taking the sugar millers, flour millers, the middlemen, the retailers, and many other groups head-on without doing their homework. In essence, it is an issue of governance, and again the State Bank cannot be blamed for not being able to dent inflation. It brought core inflation down significantly.

In short, the State Bank raised the policy rate when the economy was overheated and prices were soaring. It brought it down to support the economy when the pandemic struck. But determining the optimal policy rate is a complex decision. It involves intricate models, simulations, and calculations, even if with some judgement. That is what the State Bank is there for. Let it work.

The writer teaches economics and development at SZABIST, Islamabad.

Published in Dawn, May 17th, 2021

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