DOSA ECONOMICS: How falling Interest Rates on deposits is not always bad?

The Dosa economics of Raghuram Rajan explains the negative impact of high inflation on our purchasing power. But we already know that inflation is bad, right? So why the RBI governor had to coin the concept of Dosa economics?

so, here we are taking interest rates of fixed deposit (FD). Actually our senior citizens think differently. Their ambitions are taken care of their family & their priorities are different. Basically they are concerned about long term effect of high inflation, but it is depressed. For them fall in FD rates means fall in their income.

It is for that Raghuram Rajan used the term dosa's to explain how they must solve the puzzle of low FD rates.

Before that we have understood two terms of of Raghuram Rajan that helps us to better understanding.

1. Nominal Interest Rate:-

The interest rate offered by the bank on term deposit deposit is called Nominal Interest Rate. For example, if SBI is offering 5.5% interest rate on FD's as on July '20 then 5.5% is Nominal Interest Rate.

2. Real Interest Rate:-

The net return on deposit, Raghuram Rajan calls it as Real interest Rate. It is FD interest rate minus inflation.

Explanation-

Suppose a senior citizen has 1,00,000 as savings. At the point of time market rate of Dosa's was Rs 50 per Dosa. So, person can buy 2000 numbers of Dosa's. So, the purchasing power of Rs 1,00,000 at the moment of time is 2000 Dosa's.

Now let's assume that he has two markets available for him for investing.

The first market is "high inflation, high interest rate" market. And the second market is "low inflation, low interest rate"market. Let's see what happens if he invest either of them.

Market #1:-

The current interest rate offered on FD's is 10%. Hence, after the end of 1 year, income generated by investment of Rs 1,00,000 is Rs 10,000 at the same time inflation was 10% per annum, price of each Dosa rose from Rs 50 to Rs 55. This means from interest income of Rs 10,000 could buy 182 numbers of Dosa's (10,000/55).

Market#2:-

The current interest rate is offered on FD's is 8%. Hence, the end of the year, income generated by investment of Rs 1,00,000 is 8000 at the same time inflation was 5.5% per annum, price of each Dosa rose from Rs 50 to Rs 52.75. This means from interest income of Rs 8000 could buy only 152 numbers of Dosa's (8000/52.75).

So people in market#2 conclude that market#1, high interest rate regime is better. Why? Because in market#1 people can buy more dosas.

I'm sure that majority of people will opt market#1 ( BUT THIS WILL BE A MISTAKE).

High interest, high inflation is never good for either economy or for its people. Ok, let's understand more about it.

The fallacy of high interest regime:

High interest rate might look good. But we must not forget that high interest regime is always backed by high inflation.

Whenever inflation begin to rise and reach beyond a level it becomes uncontrollable. Then what is that level where we can say that inflation is crossing it's limits? A point at which interest rates on FD's becomes Lower than inflation rate. At that point Net Return / Real interest Rate becomes negative.

Now, what happens when Net Return is zero or negative.

This is the situation where our investment are actually yielding zero or negative returns. But it is not visible to our eye. This has been beautifully explained by Raghuram Rajan sir about Dosa Economics.

You can see above that market#2 has the positive net return. Hence, through market#1 was at high interest, but still purchasing power is inhanced (after 1 year) in market#2.

Conclusion- 

Focus should be on real returns ( Real Interest Rate) and not only in Nominal Interest Rate.