Economics sounds quite complex with the number of jargons and complicated terms. In such cases, examples can be quite helpful. And using an everyday food item like Dosa can be even more so. This is why Raghuram Rajan’s latest speech on ‘Dosa Economics’ has caught everyone’s fancy. Rajan is the Governor of the Reserve Bank of India.
Let’s understand what Dosa Economics aims to explain:
First, the basics – inflation v/s interest rates:
Interest rates are directly proportional with inflation. When inflation rises, the RBI increases its interest rate for lending. This is the rate at which the RBI – and other banks – lends money. This makes loans costly.
However, such a rise (or a fall) has an effect on the Deposit rates too – the interest you get on your Bank deposits like Savings Account, Fixed Deposits, etc.
So the bottom line is, inflation not only affects how much you spend, but also how much you manage to save.
Why Dosa Economics:
The RBI governor receives letters from pensioners quite often. Recently, he received a letter which requested the banks to increase their interest rates. This is because the pensioner believed that a higher interest could help him save better. After all, a higher interest rate may mean costlier loans, but also higher deposit rates.
The ‘Dosa’ Example:
Raghuram Rajan explained that even though interest rates are lower, low inflation rates will still allow pensioners save more. He used a Dosa to explain this phenomenon. Suppose each Dosa is priced at Rs 50 and as a pensioner, you have savings worth Rs 1 lakh. So these savings will help you buy around 2,000 Dosas. This is your purchasing power.
As inflation rises every year, the price of the Dosa will increase. So you will not be able to afford the same number of Dosas. Suppose, the Dosa price rises by 10% to Rs 55, then you can only buy 1818 Dosas. You will need Rs 10,010 extra to buy the remaining 182 Dosas.
This extra money can come from the interest payments on your savings and Deposits. These can be used to help you buy the same number of Dosas irrespective of inflation (if not more). You just need to earn 10.01% interest on your savings to be able to buy the remaining Dosas.
So, the rate of interest you earn on your savings should be higher than the inflation rate. Otherwise, the interest payments may not be sufficient.
Lower Interest Rates, Inflation:
In the recent past, the interest rates have fallen to 8%. This is because inflation has slowed. Prices are rising at much slower rate of 5.5% compared to 10% earlier.
So, the pensioner may be earning lower interest rates, but he/she is still benefiting better. This is because the price of Dosa only increased to Rs 52.75 rather than Rs 55. This means, the pensioner can afford 1896 Dosas today – a good 78 Dosas more. He only needs to buy 104 Dosas more, which costs Rs 5,486. Earlier, he needed to buy 182 Dosas which cost Rs 10,010 – nearly double!
Moreover, the pensioner is earning 8% interest rate today (Rs 8,000) instead of 10% or Rs 10,000 earlier. This means, he actually ends up profiting Rs 2,514 today. Earlier, he would have either ended with no gains or worse, a loss.
Why Inflation Needs to be Low:
Today, with a lower inflation rate, the pensioner can actually afford nearly 48 Dosas extra. This is despite a lower interest rate. This is why inflation is better – and more profitable – when it is low. People’s real savings end up higher.