Explainer: Some things you were afraid to ask about inflation and interest rates

The government doesn't want you to spend money -- in a nutshell

Web Desk

Updated 03 Mar, 2023

Pakistan

The following sentence makes most people’s brains freeze: Pakistan’s central bank has announced that it has increased the interest rate by 300 basis points to 20 per cent — the highest since October 1996 — citing rising inflation.

Not everyone has a degree in macro-economics (neither do we) so making sense of these important decisions is hard. Fortunately, we were able to reach out to some of our colleagues at the Business Recorder to get a grasp on it. We have no shame in admitting we also struggle to understand it.

The supply of money or rupees in the circulation in the economy is determined by the central bank, SBP.

One of the ways in which it controls the supply of money is by controlling the rate at which it lends money to banks. This is the interest rate. If the SBP raises the interest rate at which it lends and borrows from banks, this squeezes the money supply. If they reduce the rate, that increases the supply of money.

One of the ways to tackle inflation is to control the supply of money. The typical prescription for rampant inflation is to cut down the demand for goods and products in the economy. One way to do that is to cut government spending. Another way is or simply cut the amount of money that is available in circulation.

When the interest rate is raised, people will gravitate towards putting money in the bank and saving. They will spend less.

The lever results in a reduced money supply.

The impact is that this slows down the economy on the whole as well. That is the effect when the central bank tries to curb prices.

The State Bank of Pakistan — also called the central bank because it provides policy benchmarks to commercial banks — has increased the interest rate by 3% or 300 basis points (bps). This means three things and all of them are connected.

The central bank has justified the interest rate increase by saying that inflation is rising. The inflation rate hit 31.5% in February.

Everything that you bought with a Rs100 bill in February 2022 now cost Rs131.5 in Febraury 2023. This is one way of understanding inflation and in this context, inflation has the same meaning as a price increase.

Another way to think about inflation is in terms of the money supply, namely, the amount of money people have with them. If more people have money and they are willing to pay for a product, the seller will inevitably demand a higher price.

But if the government offers some incentives to people to not spend the money they have, there would be fewer buyers and the money in circulation will drop. Thus, the seller will be forced to reduce the price of the product.

The government incentive comes in the form of a high-interest rate. The interest rate hike simply means the government is telling you not to spend your money and keep it with banks and in return, banks will pay you higher interest or returns.

This is how the government keep prices or inflation lower.

Since everyone follows SBP interactions, all banks will now increase the interest on loans they have given to people by at least 3%. So, borrowers will be paying banks more in their equated monthly installments (EMIs).

For example, if your father has taken a Rs1 million loan for five years, after the interest rate goes up, his monthly payment back will increase from Rs32,353 to Rs34,220 at the least.

He will have to find the extra Rs1,867 by cutting some other expenses. Amid rising inflation, it could be an uphill task.

We have explained the same problem here.

The interest rate also affects credit cards, so people will think a little longer before taking it out to pay for something. It also affects car and house financing, so higher car loan repayments might discourage people from making a purchase. With people a little more reluctant to buy, prices might start to go down.

The risk is that this slows down the economy. The number of buyers could go so low that no economic activity (read buying and selling) takes place.

The bank has to try to find a line between encouraging people to spend less money, but not too little lest all economic activities grind to a halt.

While people are already looking to spend less given mounting prices and stagnant wages, it remains to be seen if inflation will take a hit by the SBP announcement on Thursday.

For the latest news, follow us on Twitter @Aaj_Urdu. We are also on Facebook, Instagram and YouTube.