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India's central bank raises key interest rates by quarter point to contain inflation
One of a governments macroeconomic goals is price stability and an
attempt to maintain a low and stable rate of inflation. Inflation is defined
as a persistent increase i n the average price level of the economy.
Inflation is measure through the Consumer Price Index. It indicates a fall
in the value of money when the economy is at or approaching the point of
full employment.
This article concerns itself with Indias decisi on to increase interest rates
in an effort to suppress levels of inflation. Inflation can be a cause of
various economical changes such as increasing aggregate demand in a
country or an increase in the cost of production of goods. Low interest
rates in a country encourage consumers to buy more, eventually leading
to a greater demand than supply; causing inflated prices .
The diagram below shows us quite clearly how the Demand Pull Inflation
works. Demand Pull Inflation, as the name itself suggests is caused by an
excessive demand in the market.This demand results in an increase in
average prices and also real output.

Cost Push Inflation is caused due to an increase in cost of production. An
increase in costs lead to a fall short run aggregate supply from SRAS 1 to
SRAS 2 reflecting increase of prices.

The author mentions the effects of inflation in the economy and the rising
prices of consumer goods in the Indian Economy- "India's inflation rate
jumped to 8.4 per cent in December as prices climbed for fruit,
vegetables, manufactured goods and fuel.
The author then goes to state the decision of The Reserve Bank of India
to increase their interest rates . Usually, commercial banks make their
money from charging interest to those people who borrow from them. If,
there is a high rate of inflation, then banks raise their nominal interest
rates in order to keep the real rate that they earn positive.
As Inflation leads to a rise in the general price level money loses its
value. When inflation is high, people may lose confidence in money as the
real value of savings is severely reduced. Savers will lose out if nominal
interest rates are lower than inflation - leading to negative real interest
rates. Consequently, there has been a 0.25% (from 6.25% to 6.50%)
increase in the banks interest rates on loans that are being borrowed. It
is simple to understand that an increase in these rates, dissuade
consumers from taking loans eventually preventing the public in India
from consuming more.

The diagram below shows an actual fall in the prices ( a suitable solution
to level the increase in prices in India)- " inflationary pressures, which
were already strong, have intensified in emerging economies due to sharp
increases in food, energy and commodity prices. In actuality, aggregate
demand is gradually increasing over time so higher interest rates tend to
slow up this increase rather than actually reduce the aggregate demand
itself; prices still increase but not as fast as they would have otherwise.

The economic approach of increasing interest rates is Monetary in nature. The
Government of India is setting monetary policy objective to target inflation. Whilst
increasing the interest rates the government keeps in mind the rate of increase of
average earnings, house prices, the exchange rate, the output gap etcetera. .
Since demand for money is interest inelastic, any decrease in the money supply
leads to a large increase in interest rates and has a large effect on aggregate
demand. Investment however, is money elastic and so any change in interest
rates has a significant effect on aggregate demand. Investment is not vulnerable
to changes in expectations and so a rise in interest rates will decrease aggregate
demand; eventually decreasing inflation.

The author also briefly mentions briefly states that economies of `more
developed nations such as United States of America are also recovering
from recession, faster than expected. However the author fails to put light
on how this is taking place there and whether the U.S government is
using the same Monetarist method by increasing interest rates like in

It is evident from the article that the Indian Economy is slowly and
steadily coming out of recession. Measures at controlling inflation in India
have been successful especially in the Agricultural Sectors of India. The
growing economy of India continues to go even through the inflation-
"The robustness of growth is also reflected in corporate sales, tax
revenues and bank credit, notwithstanding some moderation in the index
of industrial production."