Game of Nominal Interest Rate, Inflation and Real Interest Rate | Basics
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Imagine you are responsible for the economic growth of a country, state or a geography. You need to first decide what your economic goal is and what are the suitable nominal interest rate, inflation and real interest rate for that. The rest of the government and central bank decisions should be to maintain these three targeted parameters.
In this post we will try to understand the game of these three economic parameters. This post has helped me in understanding the world better and in defining my economic role in society.
I hope you will enjoy it.
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You have learned about inflation in the older post. If you want to go through the basics again, please go through it before we move on to today’s post.
We have also learned how fluctuating interest rates affect economies. And what can you do to save or boost your wealth during these changing interest rates? Check the following article to solidify your basics before moving ahead.
Now, once we are aware of the importance of nominal interest rate, real interest rate and inflation. Let’s see what is an ideal nominal interest rate, inflation and real interest rate for an economy? What will happen if they go out of normal on both sides of axis?
There's no universally "ideal" set of rates that applies to all economies, as optimal levels depend on various factors specific to each country. However, I can discuss some general principles and potential consequences when these rates deviate significantly from typical ranges.
Nominal Interest Rate:
A moderate nominal interest rate is generally considered beneficial. In many developed economies, this might be in the range of 2-5%.
Inflation Rate:
Most central bank’s target a low, stable inflation rate, often around 2% annually.
Real Interest Rate:
The real interest rate is the nominal rate minus inflation. A slightly positive real interest rate (e.g., 1-3%) is often seen as healthy.
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Now, until and unless a country has a difficult situation, they all aspire to reach an economic development stage where they can maintain these levels of rates. Generally, all developed economies maintain these levels of rates.
Later in this post we will also understand what those difficult situations are and how countries can behave in them but before that let’s understand why these levels are so important and what do they represent.
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These levels represent a healthy economy. Now let us understand what are the characteristics of a healthy economy and how these rates help to manage them.
Healthy zero risk growth rate for wealth of masses: Overtime needs of a family increases. They need funds for the education of their children, a cushion for any bad incident, etc. So, they need their wealth to grow in real terms not in nominal terms. There are multiple ways to achieve this growth but that often come with higher risk. A healthy economy should provide an easy way for the masses to grow their wealth and that often comes in the form of bank savings. Here, a real interest rate of 1-3% seems a good rate of growth. Masses can save their money in banks (with different instruments) and grow it at this rate.
Healthy capital formation: As more people save, banks have more money to lend. This pool of savings is called "capital." It's the fuel that businesses use to grow, invest, and create jobs. In this way capital of the masses is used to further fund economic growth. Banks in between act as a risk absorption entity. Here, a real interest rate of 1-3% seems to be good to maintain this capital formation rate.
Healthy economic growth: Low to moderate interest rates encourage borrowing and investment, stimulating economic activity. Higher real interest rates will slow down economic growth as people will not invest in new projects and very low interest rates make the capital free for riskier projects (projects with negative returns). Here, a real interest rate of 1-3% seems to be good to maintain a healthy borrowing rate or cost of capital for businesses to make reasonable investments.
A low, positive inflation rate: Now, let's explore why a low, positive inflation rate is often seen as good for the economy. First, it helps in avoiding deflation. Deflation is when prices fall over time. While this might sound good, it can be harmful as people might delay purchases, thinking things will be cheaper later. This can slow down the economy. Debts become harder to pay off as money becomes more valuable over time. Businesses might have to cut wages, which is difficult and can lead to job losses. A low, positive inflation rate acts as a buffer against deflation. It gives central banks room to lower interest rates if needed to stimulate the economy during tough times.
Second, it encourages spending and investment. When people expect prices to rise slightly, they're more likely to make purchases or investments now rather than wait.
Third, it allows wage flexibility. It's easier for employers to give small raises or adjust wages when there's some inflation. Cutting wages (in a zero or negative inflation environment) is much harder and can hurt morale.
Now, the last characteristic is Stability.
Stability ensures predictability: Moderate, predictable rates provide economic stability and allow for better planning by businesses and consumers. Stable interest rates make the cost of borrowing predictable for businesses. Stable inflation helps them in predicting supply chain costs and prices of their finished products. Consumers can also plan their big purchases like car, home, etc.
Consequences of significant deviations:
If rates are too low:
Inflation risk: Very low interest rates can lead to excessive borrowing and spending, potentially causing high inflation.
Asset bubbles: Low rates may drive investors to seek higher yields in riskier assets, potentially creating bubbles.
Reduced saving: Near-zero or negative real interest rates discourage saving.
If rates are too high:
Economic slowdown: High interest rates can stifle borrowing and investment, slowing economic growth.
Increased unemployment: As businesses cut back on investments, job creation may slow.
Currency appreciation: High interest rates may attract foreign capital, potentially making exports less competitive.
Debt burden: For heavily indebted nations or individuals, high rates can significantly increase debt servicing costs.
It's important to note that the "ideal" rates can vary based on an economy's stage of development, structural characteristics, and current economic conditions. Central banks and policymakers must constantly assess and adjust these rates to maintain economic stability and promote growth.
Let’s segment countries into broad categories based on their development stage and other economic factors, then discuss what might be considered appropriate rate ranges for each group. Keep in mind that these are generalizations, and individual countries within each group may have unique circumstances that call for different approaches.
Advanced Economies
Examples: United States, Japan, Germany, United Kingdom, Canada
Characteristics:
High per capita income
Developed financial markets
Strong institutions and rule of law
Generally stable economies
Typical rate ranges:
Nominal interest rate: 1-4%
Inflation rate: 1-3%
Real interest rate: 0-2%
Rationale: These economies typically aim for price stability and sustainable growth. They can maintain lower rates due to their economic stability and developed financial systems.
Emerging Market Economies
Examples: China, India, Brazil, Mexico, Indonesia
Characteristics:
Rapidly growing economies
Developing financial markets
Increasing integration with global markets
Often higher growth rates than advanced economies
Typical rate ranges:
Nominal interest rate: 4-8%
Inflation rate: 2-6%
Real interest rate: 1-3%
Rationale: These economies often need slightly higher rates to control inflation and attract foreign investment. They balance the need for growth with maintaining economic stability.
Developing Economies
Examples: Many countries in Africa, parts of Southeast Asia, some South American countries
Characteristics:
Lower per capita income
Less developed financial markets
Often commodity-dependent economies
Higher economic volatility
Typical rate ranges:
Nominal interest rate: 6-12%
Inflation rate: 4-8%
Real interest rate: 2-5%
Rationale: Higher rates are often necessary to combat inflation, stabilize currencies, and attract investment. However, rates that are too high can stifle economic growth.
Frontier Markets
Examples: Vietnam, Bangladesh, Nigeria, Kenya
Characteristics:
Rapidly evolving economies
High growth potential
Less liquid financial markets
Higher risk profile
Typical rate ranges:
Nominal interest rate: 8-15%
Inflation rate: 5-10%
Real interest rate: 3-6%
Rationale: These economies often require higher rates to manage risk, control inflation, and attract investment. Higher returns are necessary to compensate for the increased risk.
Economies in Transition
Examples: Some Eastern European countries, former Soviet republics
Characteristics:
Moving from centrally planned to market-based economies
Undergoing significant structural changes
Often experiencing rapid institutional development
Typical rate ranges:
Nominal interest rate: 5-10%
Inflation rate: 3-7%
Real interest rate: 2-4%
Rationale: These economies need to balance fostering growth with maintaining stability during significant economic transitions. Rates are often higher than in advanced economies but lower than in developing ones.
Factors Influencing Ideal Rates:
Economic growth rate: Faster-growing economies may tolerate higher inflation and interest rates.
External debt levels: Countries with high external debt may need higher rates to attract foreign capital.
Political stability: More stable countries can often maintain lower rates.
Natural resource dependence: Resource-rich countries may need to manage inflation from commodity price fluctuations.
Demographics: Aging populations might require different rate strategies compared to younger, rapidly growing populations.
It's crucial to note that these are broad generalizations. Each country's ideal rates will depend on its specific economic conditions, policy goals, and external factors. Central banks and policymakers must continually adjust their approach based on changing economic circumstances and long-term development objectives.
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ABOUT THE AUTHOR
Hey everyone, I'm Garvit Sahdev 😎. I'm on a mission to gain a deeper understanding of the world, and to develop solutions that can trigger significant global change.
My curiosities span various domains including food, business theories, material science, market size calculations, economics, politics, and sports, etc. 🧐
Professionally, I have a diverse background spanning startups, consulting, policy development, market research, system building, ISO, colour physics, nanomaterial synthesis, textile chemistry, etc. 🐘
Note: Generative AI has been used for writing this piece under the supervision of the author.
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