What is Dosanomics?
Dissecting Raghuram Rajan’s theory on inflation and interest rates
Dosa is the great Indian Unifier!
It doesn’t matter what part of the country you come from. We all come together to a plate of steaming hot spicy aromatic Dosa.
When Rajan became Governor, banks in India were offering a high rate of interest(about 10%) but the inflation rate was also very high(about 10%).
Rajan was known for his brave and often unpopular steps when it came to bringing India’s economy on track. He worked with a vision to cut down inflation and bring out large scale financial inclusion in the Indian population.
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One such decision was to lower interest rates on Fixed Deposits from 10% to 8% when Inflation came down to less than 5%.
This was a matter of grave concern, especially among aggrieved retirees (the conservative term deposit lovers). They alleged,
“Earlier we used to get 10% interest on fixed deposits. This has been reduced to 8%. We don’t know if we will be able to make ends meet.”
In response, Rajan explained his move and why high inflation is the “silent killer” of growth. He drove his point home using our beloved ‘Masala Dosa’. Hence, the name Dosanomics.
In this article, I will try and break down his explanation using two scenarios: high inflation, high-interest rate and low inflation, low-interest rate.
Let us suppose that a retiree has a total saving of Rs 1,00,000. He wishes to use this money to buy our beloved Masala Dosa. Now, the cost of a Dosa today is Rs 50. So, today he can buy 2000 dosas with his saved money.
But the retiree knows that he can invest this money in a term deposit and the next year he will have more money to buy dosas. But, quite often we don’t account for inflation. Let me explain further.
Scenario 1: High-Interest Rate, High inflation 10%
The retiree knows that if he puts his money in a bank’s Fixed Deposit at 10% p.a. for one year, he will be able to buy 10% more dosas next year.
So, by the end of the year, he gets back his principle of Rs 1,00,000 and an interest of Rs 10,000. So, he can buy 220 dosas of Rs 50 each. Right?
What’s the catch here? Inflation!
As the economy is experiencing 10% inflation this year, the price of Dosa increased from Rs 50 to Rs 55. So, with his Rs 1,10,000, he can still buy only 2000 Dosas. So, the net gain of investing in a term deposit was zero.
His purchase power is still the same: 2000 Dosas.
Scenario 2: Low-Interest Rate, Low inflation 5.5%
Now, let’s say the economy was experiencing a 5.5% inflation rate. With an 8% interest rate, the retiree would have Rs 1,08,000 in his account. The rate of a Masala Dosa now is Rs 52.75 (because of a 5.5% interest rate).
This would allow the retiree to buy approximately 2048 dosas.
High Inflation; High-Interest Rate — 2000 Dosas.
Low Inflation; Low-Interest Rate — 2048 Dosas.
Dosanomics tells us that the retirees are earning (48/2000) 2.5% more Dosas even with lower interest rates!
Rajan once claimed that he has yet to meet an industrialist that doesn’t want the interest rates to be lowered. Also, no retiree doesn’t complain about the low rates on deposits. The only way to get them together is to holistically lower inflation.
In a Q&A session, an engineering student probed “Dosanomics” even further. He questioned Rajan why even with the inflation rates are lower, the dosa prices still continue to rise. He pleads, “What is happening to our beloved Dosa sir?”
With a sly smile, Rajan responded, “You have hit on another issue in economics, which is called the Balassa-Samuelson effect.”
Balassa-Samuelson effect states that countries with high growth in productivity also have high wage growth.
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Rajan explained that the technology for making Dosas hasn’t improved much. But, staff wages are constantly increasing. While workers in factories and banks can now serve a larger audience because of technological advances, the dosa business hasn’t been scaled yet.
Balassa — Samuelson Effect states that in a fast-growing economy like India, the sectors that aren’t improving their technology will see higher price inflation than others.
Thus, the overall effect is that citizens of developing countries have to endure high inflation. Often governments keep interest rates high to relieve the inflation pressure from the lowest income group.
It provides a false feeling of security that they can live their life on interest and leave the principal for their kids.
But like we saw earlier, they fail to take inflation into account.
Inflation brings down the purchasing power of money!