BCom 3rd Year Inflation Interest Rates India Study Material notes

BCom 3rd Year Inflation Interest Rates India Study Material notes: Bond Rate or Coupon Rate  Table Bill Market Rate Deposit Rates Other Interest Rates Instruments for Regulation of Rate of Interest Other Interest rates Inflation Rate Measures to Control Inflation Exercise Question Long Answer Questions Short Answer Question Following Statement True False  Choose Correct Option :

BCom 3rd Year Nature Importance Financial Money Study Material notes in hindi

INFLATION AND INTEREST RATES IN INDIA

Different kinds of interest rates are in use in India. Some examples are – bonds or coupan rate, bill market rate, deposit rate etc. Inflation influences all these rates. Interest and principles related to its fixation/calculations have been discussed in details in the previous lesson. So, in this lesson, we shall study different kinds of interest rates operating in India.

BOND RATE OR COUPON RATE

A Bond is a certain period security issued by the government of a country. A certain rate of interest is obtained on it. Obviously, a bond has a certain Face Price, on which a certain annual interest is procured. The rate at which interest is obtained on the bond is called the bond rate or coupon rate.

The history of issuing bonds by the government is very old. Bonds in India were issued for the first time by the British government to raise funds in 1693 after the War of France. Thus government takes loans from people through bonds and gives interest on a certain rate.

Initially bonds were issued only by the government, but these days even non-government organisations and companies have started issuing bonds in the form of Certificate of loan i.e. debenture. In section 2 (12) of Indian Companies Act, 1956 debentures and bonds have been called a kind of security. The fundamental difference between debenture and bond is that the rate of interest is predetermined in debenture, while bond can be issued without pre-determined interest rates. Zero Coupon Bond is an example of it.

Zero Coupon Bond referes to such security on which interest is not paid directly but it is issued on discount. In other words, it is issued on a price less than its Marked Price and its redemption is made on the Market Price.

Relationship between Bond Price and Bond Rate : Bond Price and Bond Rate are inversely proportional. It means if Bond Price goes up, the Bond Rate will go down and if Bond Price goes down, the Bond Rate will go up provided that it is a previously issued bond. Following example can clarify it:

(a) Suppose the Market Price of a bond is 1000 and the rate of interest is 6 per cent annual. Now suppose this bond was purchased when its price was 100

1200. In this condition the rate of interest will be 1000 x 6 = 5 per cent.

(b) Similarly, suppose a bond having the Market Price 1000 was purchased when its price was reduced to 800. In this case, the rate of interest will be 1000

x6 = 7.5 per cent. 800

The common bond rates in India in the last few years have been shown in the following table.

BCom Inflation Interest Rates

BOND RATE TABLE

Note: The above rates are based on monthly average.

BILL MARKET RATE

Bill Market Scheme was launched in India on 16th January, 1952 by Reserve Bank of India. It is a short term loan makret. The purpose of developing this market is to increase the avaiability of short-term credit for trade and industry. Under this scheme, the Reserve Bank of India has given the facilities to the Commerical Banks of India that they can convert demand deposits in the form of cash credit, overdraft or loans into bills. Then the commerical banks can take loans from RBI on the guarantee of these bills. Besides this the bill market can be associated to that system in which entrepreneurs and governments are provided loans by commercial banks or discount house by discounting of bills.

Bill Market Rate is that rate on which discounting of bills is done. Many amendments were made by the RBI in India to encourage the bill market, but due to many reasons the bill market could not develop properly. Again in 1970, on the basis of recommendations of a study group a new bill “re-discounting Scheme” was introduced, but it could not be successful. [Its detailed analysis has been done in the chapter-Financial Market : Instrument and their Functions.]

Indian Bill Market is a part of Indian Money Market. An important reason for the failure of this marekt is considered the absence of discount houses. But after the establishment of DFHI (Discount and Finance House of India) in 1988, the money market got a new direction. This institution was set up by the combined efforts of the Reserve Bank of India, Public sector Banks and other big Financial Organisations. Established under the Indian Companies Act, 1956, the Authorised capital of this organisation was 100 crores out of which the shares of RBI, Public Sector Banks and other Financial Organisations were 51 crores, 33 crores and 3 16 crores respectively. The rates of discounting of bills have been changing from time to time.

DEPOSIT RATES

Accepting deposists from people through various accounts is the primary function of Commerical banks. Banks pay a certain interest rates on these deposits. Thus, the rate at which banks grant interest on peoples deposit is called the deposit rate. It is also worth mentioning here that the rate of interest varies on different types of deposits. Most of banks don’t pay any interest on current account. The rate of interest is very low (generally 3 to 3.75 % on saving accounts. Maximum interest is paid on Fixed Deposit Account. It is not essential that every commerceal bank should give interest at an equal rate. Different! banks have freedom of determining different interest rates according to the period of deposits under the maximum limit determined by the RBI.

The interest rates of different banks on Fixed Deposit Account have been shown in the following table :

Table (Rate in %) (Effective from September, 2012)

BCom Inflation Interest Rates 

These rates may change from time to time. Like banks, post office also accepts deposits through various accounts. Different rates of interest are paid on these deposits. It is called post office deposit rate.

OTHER INTEREST RATES

(1) Call Rate : Such loans granted by financial institutions which can be recovered on a short notice are called Call Rate Loans. The interest charged on this loan is called ‘Call Rate’.

(2) Aministrated Interest Rate : The rate of interest charged by the govenment or authorised institution is called Administrated Interest Rate.

(3) Prime Lending Rate (PLR): PLR refer to that interest rate at which a bank offers loan to customers with good reputation/credit.

To make the credit market more transparent and to provide the old customers loans at minimum cost. Instructions regarding this are given by RBI from time to time.

INSTRUMENTS FOR REGULATION OF RATE OF INTEREST

Following are the instruments for regulation of rate of interest in India.

(1) Bank Rate : Bank rate is the rate at which the RBI gives loans/advances to commereical banks and discounts their trade bills. An important cause of increase or decrease in bank rate is the expansion and contraction in the amount of credit in the market. That is why it is also called the Reference Rate. At present the bank rate is 6 per cent.

(2) Open Market Operations : Reserve Bank of India influences the interest rate by the open market operation like purchasing and selling government securities, first class bills and promissory notes. The rate of interest is indirectly influenced by it.

(3) Variable Cash Reserve Ratio (CRR): The RBI influences the interest rate by checking the liquidity of commereical banks through CRR. The RBI maintained CRR at 5% on 21st April, 2009 when different rates were declared. It is worth mentioning here that on 5th March, 2009 also it was 5 per cent.

(4) Statutory Liquidity Ratio (SLR): According to it the commereical banks of the country have to keep a certain per cent of their deposits with them in the form of liquid cash. The higher is this rate the lower will be the ability of banks to grant credit. Interest rate is also influenced by bringing a change in the amount of granting credit. At present this rate is 24 per cent.

(5) Selective or Qualitative Credit Control : Selective or qualitative credit control referes to that technique of credit control under which RBI issues orders to provide credit to member banks to fulfill certain objectives. According to this system of credit control RBI fixes the maximum limit of credit in certain fields. No bank can provide loans beyond this limit without prior permission from RBI. Monetary interest rate is also influenced by its use.

INFLATION RATE

In common words, when the prices of goods and services go up and the value of money start going down, this situation is called inflation. Among the economists Hawtrey has said, “The situation in which there is over-flow of money is called inflation.”

But now economists, while defining inflation, tell that when the prices of commodities rise and against it the standard purchasing power of money declines it is called inflation. In fact, due to financial policy, the supply of money can be made upto a certain limit only. So, there can be no question of overflow of money.

The measurement of inflation is done on the basis of change in the average price of groups of commodities at two different times In its calculation generally those commodities are included which are of general use. The interest rates are also influenced by inflation. The inflation rates at different times in India have been shown in the following table :

TABLE

Monthly Wholesale Price Index Base year 2004-05 = 100 (weight 100)

BCom Inflation Interest Rates

Note: The above data are based on the monthly average of all commodity.

Source : Ministry of Commerce and Industry, GOI.

Inflation rates influence the deposit rate of interest. Those investors who invest their money in the sectors with stable income viz-debentures, bonds etc. face a loss despite obtaining a certain income because the purchasing power of their income decreases during the inflation period. But those investors, who invest in the fields with unstable income viz-equity shares of companies, earn profits in most of cases, because profits of companies increase during the inflation period. Consequently the shareholders get a higher rate of dividend.

Inflation Adjusted Rate Interest : Inflation is a monetary event. In the event of inflation, an adjusted rate of interest is obtained. Inflation Adjusted Rate of Interest can be obtained by subtracting the rate of inflation from the monetary interest rate. For example, if the rate of interest on any share is 14 per cent and the inflation rate is 13 per cent, then the actual rate of interest will be 14% – 13% = 1%.

As all kinds of interest rates are closely related, all kinds of interest rates are influenced by inflation. If there is a pre-conception/prediction of inflation, the high interest rates are determined so that a fixed actual interest rate can be obtained. For example, if the predicted inflation rate is 8 per cent and a creditor wants to get the actual interest rate to be 7 percent then the rate of interest is fixed to be 15 percent. This is clled Fisher Effect.

Inflation often has negative effects on interest rate. As it finfluences saving holders, investors and the monetary management of the government, it has to be regulated.

MEASURES TO CONTROL INFLATION

Prevention of inflation is necessary to control the economy. Generally three steps are taken to check the inflation :

(1) Monetary Measures : Those measures which are adopted by the Central Bank of India to regulate money and credit are included in the monetary measures. These are as follows:

(i) To Maintain Control Over Money: Regulating the amount of money is an important step in the direction of checking the inflation. So the Central Bank takes securities at the time of issuing notes. The Central bank must be very careful while issuing new currencies.

(ii) Credit Control : Inflation can be controlled by regulating the credit policy also. For this, the Central Bank should keep a high bank rate and the government securities should be sold in the open market. Moreover, the Central bank should have proper control over the credit creation of commerical banks.

(iii) Replacement of Old Money to New Money : When the inflation rate takes a giant form, Old money should be replaced by new one.

(2) Fiscal Measures : Following measures are included in it:

(i) Increase in Taxes : To check the inflation, the government should increase the old taxes imposed on people and impose new direct and indirect taxes on people to reduce the surplus purchasing power of people.

(ii) Reduction in Public Expenditure: During the inflation, the government should regulate/reduce the public expenditure. Particularly, non-productive expenses must be stopped instantly. This can help in checking the price rise.

(iii) Increase in Public Debts: To check the inflation, it is essential that the government should take more and more loans from people and invest it in productive activities.

(iv) Encouragement to savings: During inflation, the government should impose tax on the consumer goods and thus discourage consumptions. At the same the government should bring new schemes of savings. But the government should not impose more taxes on essential goods.

(v) Balanced Budget: During inflation, the government should avoid preparing a Deficit Budget, because in this case there will be the need of issuing surplus notes to meet the budget deficit and it would increase inflation. So, the government should prepare a balanced budget.

(vi) Increase in Production : Increasing production is also an important measure to check inflation. So, at the time of inflation, the government should encourage such industries which can produce consumer goods quickly.

(3) Other Mesures : Some other measures of checking inflation are:

(i) Price Control and Rationing : When there is considerable rise in the price of essential goods during inflation, the government does the rationing of such essential consumer goods. It means these goods are sold through ration cards on a separate distribution system.

(ii) Subsidy : The government gives subsidy to producers to encourage production and reduce the cost of production during the inflation.

BCom Inflation Interest Rates

EXERCISE QUESTIONS

Long Answer Type Questions

1 Explain the different kinds of interest rates applicable in India.

2. Discuss the instruments for regulation of rate of interest.

3. What is inflation rate ? Explain the measures to check inflation.

Short Answer Type Questions

1 What is bond Rate ?

2. What do you understand by Coupon Rate ?

3. What is Bill Market Rate ?

4. What is Deposit Rate ?

5. What do you understand by Zero Coupon Bond ?

BCom Inflation Interest Rates

III. Objective Type Question

Choose the correct option

1 If the bond price is high, the Interest Rate : (a) Increase

(b) Decreases (c) Stays Constant

(d) Becomes zero

2. Indian Bill Market is a part of: (a) Money Market

(b) Capital Market (c) Commodity Market

(d) Foreign Market

3. What is subtracted from the monetary interest rate to get adjusted interest rate ? (a) Inflation Rate

(b) Bond rate (C) Reference interest rate

(d) None of these

4. The authorised capital of DHFI is 2……. (a) 200 crores

(b) 150 crores (c) 3 100 crores

(d) 51 crores

5. The fiscal measurement checking inflation include.. (a) Credit regulation

(b) Rationing (c) Regulating the demand of money (d) Increase in taxes

(Ans. 1. (b), 2 (a), 3. (a), 4. (c), 5. (d)]

State whether the following statements are True or False :

1 Bond price and Bond rate are inversely proportional.

2. Bill market is long-term market.

3. The rate at which banks grant interest on peoples’ deposits is called bank rate.

4. The rate at which a bank offers loan to customers with good reputation is called prime lending rate (PLR).

5. The situation in which there is over-flow of money is called inflation.

(Ans.: 1. True, 2. False, 3. False, 4. True, 5. True.)

BCom Inflation Interest Rates