Currency Induced Interest Cut

There is lot of expectation from the RBI about a possible cut in key interest rates in its upcoming policy. While the expectations of rate cut might be warranted keeping in mind the slowing economy and falling commodity prices, primarily oil, but we have to remember that there is another variable besides interest rate which is affecting the monetary conditions. And that is the Exchange Rate. This article does not try to predict the timing and extent of the interest rate cut; it only tries to explain the “other’ variable which affects monetary policy and the interlinkage and dependence between both of them.  

The economy is in equilibrium where the IS-LM curve meet – the relationship between interest rates and real output in the goods and services market and the money market. The intersection of the IS and LM curves is the "general equilibrium" where there is simultaneous equilibrium in both markets. Now, let us shift focus to the money markets and transmission of monetary policy on the aggregate demand (or prices or credit). We have to see which are the factors that affect the “aggregate demand” or “prices” in the economy.

The most noticeable feature of the aggregate demand curve is that it is downward sloping. There are a number of reasons for this relationship. Remember the downward sloping aggregate demand curve means that as the price level drops, the quantity of output demanded increases. Similarly, as the price level drops, the national income increases. There are three basic reasons for the downward sloping aggregate demand curve. These are Pigou's wealth effect, Keynes' interest-rate effect, and Mundell-Fleming's exchange-rate effect. These three reasons for the downward sloping aggregate demand curve are distinct, yet they work together.

The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Don’t forget that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand.

The second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect. Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans i.e. the interest rate decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand.

The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.

There are two monetary variables which affect aggregate demand (or somebody can assume credit growth also):

a)       Domestic Interest Rates

b)       Exchange Rate

We all know that interest rates affect the aggregate demand and result in a northward or southward shift of the “demand curve” depending on whether interest rates are increased or decreased. Exchange rate also affects the “aggregate demand” at the macro level through its effect on the exports, imports and trade balance. Hence, to find the combined effect of both, interest rates and exchange rates on aggregate demand, an index needs to be created whose formula will be somewhat like this:

   Wi (Ri – Ro) + We (Et – Eo)

Wherein

t = 0 is the base period and Wi and We are the weights derived from the estimated coefficients of real interest rate and real exchange rate from the generalized aggregate demand equation. It is from this equation that it is derived that in India 58% of aggregate demand change is explained by interest rates and the remaining 42% from exchange rates. Hence, interest rates play a bigger role that exchange rates in explaining aggregate demand. And actually also that should be the case because exchange rates are also affected by domestic interest rates. It is also pertinent whether we consider the Real Effective Exchange Rate or the Nominal Effective Exchange Rate. From the application of this formula it is derived that a the 10% nominal effective exchange rate depreciation of the Indian Rupee is equivalent to 100 bps of rate cuts in terms of impacting monetary conditions.

To conclude, I am not here to speculate whether the RBI will cut rates or no and when and by what quantum. I just want to state one thing that while we may expect the RBI to cut rates but we should alongside keep in mind that a deprecating rupee has in effect resulted in what I call as the “currency induced interest cut” of a significant magnitude over the past few months.