Low interest rates, High Inflation and low growth – A potent mix for run on the currency

Dear Mr.Chidambaram,

This blog below makes interesting reading on how to shore up the rupee.

http://blogs.reuters.com/india-expertzone/2013/08/23/how-to-rescue-the-falling-rupee/?pfrom=home-reuters

Premise : Low interest rates are in line with Keynesian theory for government to give impetus to kick start an economy especially in a recession.

The low interest rate is to allow industries to borrow and make productive use of the resources (here money).

When does this premise fail?

When people do not make productive use of their money and buy gold or silver which is usually high priced during recession. They can accentuate the problem.

When there is high inflation, low interest rates (it is a potent mix when growth is low) add to the problem by increasing  money supply. Thereby fuelling inflation which pushes down growth (in real terms).

At what times is Keynesian  theory valid and when it is not?

http://en.wikipedia.org/wiki/Keynesian_economics

If the nation is already in recession keeping the interest rates low for some time works. But it is not a long term solution. When the going is good in the economy it is better to take a ‘laissez faire’ attitude and let the market forces take over.

When do we fall back to Austrian Business Cycle Theory?

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory

If the nation is on the verge of getting into a recession (from Boom period) then ABCT works. This is because the industry can afford to pay for the loans taken. But it does not work when loan rates are very high leading to default meaning if in recession it does not work. A tight balance between ABCT and Keynesian theory needs to be followed depending at what part of the business cycle we are in.

How does ABCT work?

ABCT means short term pain long term recovery. It is a bitter pill doctor had ordered. It is the reverse of Keynesian Theory. Not lowering the interest rates mean business will have to pay for loans and they have the capacity to pay. When the first manufacturing signs say recession is round the corner then this bitter pill needs to be given. Just like Keynesian theory this also holds for special circumstances and cannot be applied at every point by the central banks.

As I have argued Keynesian theory works when the nation is in recession and Government makes effort to discourage non essential trade like Gold and silver.

ABCT works when in boom time when first signs of recession is coming.