RBI analyst

There is an inverse relationship between the change in interest rates and economic growth and inflation.
Meaning that if interest rates rise then inflation will decrease, and the economy will start to slump. However,
this relationship is not seen with the unemployment levels. If interest rates rise, then unemployment levels
would also rise as borrowing becomes expensive and firms’ main objective would tend toward saving and
decreasing costs of production.

The central bank would increase interest rates when the economy propels towards inflation. This means that the
general price levels of all the goods and services produced within the economy would increase. This situation
can happen due to excess demand for the goods and services within the country, due to excess demand the
goods and services are short in supply. As aggregate demand exceeds aggregate supply the price levels for all
the goods and services will rise. This phenomenon can be illustrated with the help of the Phillips curve. On the
contrary, this phenomenon can also take place when there is a decrease in the aggregate supply of goods and
services and this causes the cost of production to increase, which leads to an increase in the price levels of all
the goods and services in the country.

If interest rates were to increase, then the unemployment rate would also increase. As acquiring loans become
expensive firms would focus on saving costs instead of investing. Moreover, as interest rates rise firms would
lose confidence in the economy as they will think that the economy is trending towards an inflationary period
followed by a recessionary period. Thus, due to the loss of confidence in the economy and increasing interest
rates firms would make many workers redundant and try to decrease their costs of production in order to survive
during a recession. As more people are unemployed this will mean that their purchasing power will significantly
decrease. Consumers will focus on saving instead of spending as they do not have a stable source of income and
borrowing loans has become expensive. Therefore, the aggregate demand will reduce significantly, and firms
will tend to make more labors redundant. This would further increase the unemployment levels in the country.
followed by higher unemployment levels will be inflation. This would cause stagflation in the economy. As
savings will be greater than investments the economic growth rate will reduce. Due to this, there will be a fall in
the real GDP and the aggregate demand will also reduce. The diagram below shows the effect of an increase in
interest rates. As ad1 shifts leftwards to ad2 the price levels also reduce from p1 to p2 to attract customers and
survive in the market. Due to a reduction in price, the output will also reduce from q1 to q2.
As aggregate demand reduces due to high-interest rates the economy will enter a recessionary period from an
inflationary period. During the recession, unemployment levels will be high and there is structural
unemployment in the country. Economic growth and real GDP will reduce drastically.

On the contrary, if interest rates are lower then borrowing will be cheaper for households, consumers, and firms.
The aggregate demand will shift rightwards as people have more real income in their hands. The economy will
boom, and the unemployment levels will be lower than the Non-Accelerating Inflation Rate of Unemployment.
The aggregate demand will increase drastically, which will cause the economy to exponentially increase as
investments will be more than savings. As explained above, the economy will suffer from demand-pull inflation
in the future.

India’s CPI jumped, moving from 7% in March to 7.8% in April and Urban inflation soared 100 basis points to
7.1%. while rural inflation also continued its relentless climb and hit 8.4%. Food prices were still the main
engine of growth, reaching 8.5% y/y in rural India and 8.4% across the nation, the highest inflation rating since
2015. Fuel and light inflation also spiked, jumping from 7.5% y/y in March to 10.8%, as did transportation and
communication prices, hitting 10.9%. At its May meeting, the RBI raised the repo rate 40 basis points to 4.4%
in response to rampant inflation. More tightening is expected. Due to this, we can safely assume that
unemployment levels will also be great than the natural rate of unemployment. And the unemployment rate Is
7.3% and The growth in GDP during 2021-22 is estimated at 8.9 percent. The RBI should increase the interest
rates to help the economy reduce inflation. if the RBI takes this stance the unemployment levels will increase,
and economic growth will be lower. The high unemployment levels are caused due to the Covid-19 pandemic
and many skillsets have run out of demand during the pandemic. For example, there were postgraduates in
MBA, law, and engineering who were unemployed. Moreover, due to the pandemic, India faced cost-push
inflation wherein the prices of general and essential goods and services increased significantly as the aggregate
supply decreased in the economy and the cost of raw materials increased which in turn led to an increase in the
costs of production. due to inflation savings being greater than investments, this led to a decrease in economic
growth.

The RBI should employ expansionary monetary policy, mainly quantitative easing, by reducing the cash reserve
ratios. As the reserve ratio is lower commercial giving out loans will be easier. This increases the nation's
money supply and expands the economy. As acquiring loans are easier now the consumers, businesses, and
household would tend to spend more. Therefore, the aggregate demand increases and shifts rightwards. As the
RBI reduces the cash reserve ratio the unemployment levels will reduce as aggregate demand increases and
firms are therefore incentivized to produce more. due to this, the economy will grow as investments will start to
increase and savings will decrease. However, the RBI faces a dilemma due to a trade-off between an increase
in economic growth and employment levels as well as a major increase in demand-pull inflation. In economics,
every decision has an opportunity cost and the cost of increasing the economic growth and employment is rapid
inflation. However , in the long run, the economy will equilibrate as inflation soars in and the RBI will employ
contractionary fiscal policy to prevent stagflation in the country.