The real effective interest rate and foreign-competition...

Many among us are now claiming that the Reserve Bank of INDIA has reached the limit of rate-cuts following the institution’s communication that inflation and inflation expectations are biased higher in the hindsight of higher expected inflation in food and fuel that it expects inflation to be tilted to upside even when the current CPI inflation is lower than our short-run target of 4% by 2018 at 3.5%, which gives a real interest rate above than the past and that might signal that RBI must cut real interest rate in a world of negative rates. The real interest rates in a major part of the World are around negative in order to keep capital cheap to boost investment with positive inflation and nominal rates close to zero and i.e. negative real rates, nonetheless INDIA has a much higher real rate compared to the rest of the world which has a lot to do with INDIA’s competitiveness in terms of the cost of investment compared to the rest of the world, which is the ratio of nominal interest rate of the domestic economy and the foreign economy divided by the ratio of prices in the domestic economy and the foreign economy, we may call it the real effective interest rate. In other words, lower nominal interest rate and lower prices would increase competitiveness of the Indian economy and would increase demand, internal and external, lower borrowing cost would increase investment demand which is likely to increase growth. The competitiveness may come from lower input costs and prices; however there is nominal downward wage rigidity, but capital has no such rigidity which might help lower borrowing cost and prices. The lower prices would again help contain wages which would further help maintain competitiveness. In a world of free-trade and Globalization, international access of cheap inputs would help increase investment and demand, moreover lower prices would also increase consumption demand. Lower borrowing cost and higher supply in the long-run would help lower prices and as has been observed in much of the developed world, the lower real or natural interest rate as a result of lower population and demand and higher investment and supply have also helped achieve price stability and in some cases deflation, but they have also reduced demand and inflation by lowering the real wages with inflation in the past, which has negatively stroked the economic-growth in much of the developed world. Inflation is an important determinant of interest–rate and investors assume inflation against the economic-theories that inflation would go down in the long-run which is the same that has happened in the Western countries. INDIA has liberalized foreign debt by allowing credit in domestic currency with the help of bonds, but has refrained from lowering nominal interest rate and real interest rate even when globally interest rate are negative in many cases which is likely to depress the banking sector when they are reluctant to pass on previous rate cut transmissions which might push the commercial banks to lower real effective interest rate and increase demand. Competition from foreign might nudge banks to pass on the rate cuts and the RBI might further help by reducing key rates and increase money-supply. It is the relative nominal interest rate and price-level in the respective countries which decides demand, spending and the economic growth rate in a globalised world…