Are Interest Rates Too High?

Since the real rate of interest is much higher than the rate of growth of the economy, this level is not sustainable. So, even without government intervention, real interest rates would have to come down. But, those who favour government intervention argue that this process would take far too long. They want the government to act immediately.

However, government intervention is not without its attendant costs. And these costs can be particularly large, if it goes in for the wrong type of intervention. Since the government has many instruments at its disposal, it has to choose the right instrument carefully. This in turn requires it to first isolate the underlying reasons which have resulted in this sharp increase in real rates of interest.

To a large extent, the credit market today is relatively free of restrictions imposed by the government. Hence, it is a good approximation to believe that the rate of interest is determined by forces of demand and supply for loanable funds. So, if interest rates have been climbing up, this must be because one (or possibly both) of the following has happened.

Either there has been a sharp fall in the supply of loanable funds or there has been a dramatic increase in the demand for loanable funds. Consider first the demand for credit. We are all concerned with the present situation, precisely because of the feeling that at the current high rates of interest, the industrial sector will not be able to carry out its investment plans because it cannot afford the high cost of credit. At the very least, this implies that the high rate of interest could not have been caused by an increase in demand for credit coming from the industrial sector. Of course, even if there has been no increase in demand for credit from the industrial sector, there could still be an increase in the aggregate demand for credit if, for instance, the demand from the agricultural sector has recorded a significant increase. Another source of demand is the credit extended by hire-purchase companies to finance purchase of consumer durables.

There does not seem to be any evidence suggesting any large increase in credit to the agricultural sector. Given the large number of advertisements trying to lure potential customers to buy automobiles and other consumer durables on hire-purchase, one's first impression is probably that there has been an increase in the demand for consumption credit. However, it is debatable whether this increase can be of an order of magnitude which can explain the sharp increase in interest rates.

So, we are left with a supply side explanation. Are we saving appreciably less than before? Remembering that incomes have been increasing steadily in the recent past, a fall in the savings rate must manifest itself in considerably higher levels of consumption expenditure.

Unfortunately, the consumer durables sector, which should have reaped some benefits from increased consumption expenditure, has not been growing at a particularly rapid rate. It is possible (though unlikely) that the fall in the supply of loanable funds is due to significantly higher levels of expenditures on imports and consumer non-durables.

This suggests that government intervention in the credit market must be designed to augment the supply of credit. Selective credit controls, a favourite instrument of the past, is likely to be a blunt weapon under current conditions, since these operate through the demand side of the credit market.

Any attempt to impose interest rate ceilings should also be avoided since these introduce too many distortions. Fortunately, the government has a number of options which it can exercise if it wants to expand the supply of credit.