Dear Friends,
RBI Governor Dr.Raghuram Rajan, one of the worlds best Economists and credited with multiple accomplishments including:
- IIT and IIM Ahmedabad, Gold Medallist and Ph.D. from Sloan School of Management, MIT
- Won the inaugural Fischer Black Prize, in 2003, awarded by the American Finance Association for contributions to the theory and practice of finance by an economist under age 40
- Chief Economist at IMF
- Nasscom’ s Global Indian of the year, 2010
- Best Central Bank Governor in 2014 awarded by Euromoney Magazine and Central Banking Journal, London.
I will stop with this as his accomplishment are too many and would take many pages to list them. You can refer his details in the internet
Context
In one of the conventions, in Jan 2016, Rajan in his lecture tries to explain why inflation is a silent killer, in a language that can be understood by common people. In a subsequent convention at Kerala, couple of weeks later, when a lady counters him, he provides another economic concept and answers it.
Essence of the 2 events
Rajan seem to get multiple letters from people, especially Senior Citizens, complaining that the interest rates are going down subjecting them to hardships.
In his lecture, Rajan, during the first convention in Jan 2016, uses his Dosa example to address this question
“Assume that a senior citizen has Rs. 1,00,000/- and Dosas are priced at Rs. 50/- which means he would be able to purchase 2,000/- Dosas. The interest is high at 10%, like it used to be a more than year ago and the inflation is also high at 10%. So after a year Rs. 1,00,000 would have fetched interest of 10,000/- (@10%) while the price of Dosa would have gone up by 5 Rs i.e. Rs.55/-. Now the interest of 10,000/- would buy him (10,000/55) 182 Dosas approximately.
Now, if we take today’s scenario where interest rates are close to 8% and Inflation is about 5.5%, the interest that the person would fetch would be 8,000/- while the Dosa price would increase to ( 5.5% of 50) Rs. 52.75. After one year the interest that person would get is 8000 (8% of 100,000) with which he would be able to buy (8,000/52.75) approx. 152 Dosas while the previous scenario fetched 182 Dosas. But what people fail to realize if the principal erosion is less in the current scenario rather than the earlier scenario. If we look at the overall purchasing power, in the first scenario the principal plus interest of 110,000/- would fetch (110000/55) 2000 Dosas while in the second scenario the principal plus interest of 1,08,000 would fetch (108000/52.75) 2047 Dosas. He goes on to explain that we should look at Real Interest rate and not the Nominal interest rate. In the above scenario the nominal interest rates are 10% and 8%, meaning the first one is higher. But the real interest rate which factors inflation is (10%-10%) Zero and (8%-5.5%) 2.5%.
During the Kerala Convention, which happened 2 weeks subsequent to the first convention, one of the audience (young lady) countered Rajan with a question “Dosa Prices increase with Inflation but when the inflation goes down like the current scenario, no one reduces the Dosa price”
For this Dr.Rajan responded to this citing another concept in Economics called “Balassa-Samuelson effect”. He goes on to say that the technology for making Dosas hasn’t changed and it’s the same maavu is spread on the Tawa and cooked. The productivity of this person has not changed much and hence the wages keep increasing while there are other sectors where there is increase in productivity like a factory workers and clerks in banks who can handle more customers with the help of technology growth. So in a growing economy where there are sectors that are growing technologically and others where the is no growth in technology, the prices of the goods manufactured by the sectors that haven’t grown technologically goes up and this is referred as Balassa-Samuelson effect, which is the reason why Dosa prices keep going up.
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