How interest rates affect you

And who decides them in the first place!

Well, so on 8th February, RBI hiked the interest rate to 6.5%.

Today, in 5 minutes, I’m going to talk about 4 things:

• first, what is this “interest rate”

• second, how it impacts people like you and me

• third, why is this “rate hike” even done

• and lastly, how is this interest rate decided

If you feel you’re aware of any particular section, please feel free to skip to the next one. But as always, this is going to be less than 5 mins, so might as well go through everything 😉

Okay, so what is this “interest rate”

Well, in any banking system, there is a lot of money flow. We deposit money at the bank; the bank then lends this money to others and charges interest, and the bank also borrows money from other institutions.

So a bank also borrows from our central bank - the Reserve Bank of India (RBI)

(Fun fact: RBI also borrows money from banks, but we won’t get into the details there. I have just 4 minutes left to explain everything 😁)

Anyway, coming back - So when there’s any kind of borrowing done, there is an interest involved, right?

Now, when banks borrow from RBI, they (obviously) pay an interest to RBI for the amount borrowed.

And this rate at which banks borrow from RBI, is known as repo rate (or interest rate)

And on 8th Feb, RBI increased this repo rate from 6.25% to 6.5%.

Now, how does this rate hike impact people like us?

Well, this may seem confusing, but stay with me.

You see, increasing the repo rate means that banks will have to pay higher interest on the money that they borrow from RBI. And this means that the cost of borrowing for them increases. Now since the cost for banks is higher, this naturally means that they will also increase the interest that they charge to their customers for loans.

So loans will get expensive.

Now, because the cost of borrowing for banks is high, it will also give a higher interest on your fixed deposit.

So while loans will get expensive, FDs will give you a better interest. Which is why, doing an FD works better when interest (or repo) rate is high.

Okay, but why is this rate hike done?

You see, India is grappling with high inflation.

Inflation is high when prices of goods and services are high.

And prices of goods and services are high because demand is high, and people are spending that kind of money.

Now, by increasing the repo rate, RBI makes loans expensive for folks like us.

This means that now because loans are expensive, we will tend to borrow lesser money → this means lesser money for us to spend → we’ll buy lesser products/services → this means there will be lesser demand for goods and services → and lower demand will lead to lowering of prices for goods and services in general.

Essentially, by increasing repo rates, RBI tries to reduce spending and therefore tries to bring down inflation!

And that’s why we’re constantly seeing “rate hikes” - because inflation in our country is high and needs to be brought down!

Lastly, who decides these rate hikes?

So until 2016, the RBI governor used to decide on interest rates. But after that, this task lies with special committee known as the Monetary Policy Committee (or MPC).

Essentially, the MPC consists of 6 members - the RBI governor, deputy governor one RBI officer and 3 external experts appointed by the Central Government.

Here’s how the moving parts work:

RBI sets the inflation target for the year, and the MPC works towards achieving this target (The inflation target set by RBI for this year is between 4% and 6%)

This target is achieved by changing various rates, primarily the Repo rate, and also others like Bank rate, CRR, SLR etc.

(But let’s not get into the jargon and complicate this post)

Let’s come back. So the MPC meets at least once every quarter to review and discuss the monetary policy. If the inflation is within the target set by RBI, the MPC will generally not change anything. But in the recent past, since inflation has been higher than usual, rates are being changed.

Now, each member of the MPC has one vote, and the rates are decided based on the majority votes.

So you see, the fate of the entire country’s economy, resides in the hands of these 6 people 😁

To sum it up, our economy is basically managed with two broad policies (among other smaller ones):

1. Fiscal policy, where the government creates norms for spending, taxation etc (I’ll write about this some other time)

2. Monetary policy, where RBI and MPC work towards controlling the money supply in the economy

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