What is Dosa Economics of Raghuram Rajan?

The Dosa Economics of Raghuram Rajan explains the impact of inflation on our purchasing power.

But we already know that high inflation is bad.

So why the Ex RBI Governor had to coin the concept of Dosa Economics?

Our general understanding is something like this:

  • Inflation is bad.
  • Government must take care of it? What government must do?
  • Hike the interest rates on deposits.

We always seem to believe that, till we are earning high interest rates, we are safe.

But this is a misnomer. How?

There is a more complicated and lengthy explanation of this…

But allow me to explain this point by putting a simplified hypothetical example – no lecturing

High interest rates are better?

Suppose a person of 65 years of age had savings of Rs.15,00,000 (year 2013).

He put this money in Senior Citizen Saving’s Account (SCSS) in 2013.

Back then he used to earn 9.3% p.a. interest on SCSS.

It means, his Rs.15,00,000 invested in SCSS used to yield Rs.1,39,500 in 2013.

But since then, the interest rate offered by SCSS has only been depleting:

  • Mar’2013 – 9.3% (Rs.1,39,500)
  • Mar’2014 – 9.2% (Rs.1,38,000)
  • Jun’2016 – 8.6% (Rs.1,29,000)
  • Dec’2016 – 8.5% (Rs.1,27,500)
  • Jun’2017 – 8.4% (Rs.1,26,000)
  • Mar’2018 – 8.3% (Rs.1,24,500)

With the gradual descent in the offered interest rates, the income of the person has also been falling.

When the level of income falls, people start becoming restless.

We have been born to believe this fact that, income must always grow with time.

If the income is not growing, it is a problem.

But the RBI Governor Raghuram Rajan is contesting this understanding:

…falling interest rates need not always be bad….

Yes, this is what the Dosa Economics will explain to us.

But before looking into Dosa Economics, we must know the distinction between nominal & real interest rate.

Nominal interest rate vs. real interest rate

What is nominal interest rate?

The interest rates offered on deposits, bonds, loans etc is nominal interest rate.

The nominal interest rate decides the yield of ones deposit

Example#1: Interest rate of 10% per annum.

  • Lender’s perspective: The deposit will yield10 per Rs.100 invested.

In other words, when we use the word interest rate in colloquial terms, we actually mean “nominal interest rate”.

What is real interest rate?

Real interest rate = Nominal interest rate – Rate of inflation

Real interest rate considers the effect of inflation on the yield/cost.

Example#2: Interest rate of 10% per annum. Inflation rate @9% p.a.

  • Real Interest Rate: 10%-9% = 1% p.a.
  • Lender’s perspective: The deposit will yieldan effective return of Rs.1 per Rs.100 invested.

Example#3: Interest rate of 5% per annum. Inflation rate @3% p.a.

  • Real Interest Rate: 5%-3% = 2% p.a.
  • Lender’s perspective: The deposit will yieldan effective return of Rs.2 per Rs.100 invested.

What does it mean?

In example#3, the nominal return is much lower than example#2.

But in example#3, the person’s effective return (real return) is higher. How?

Because of much lower inflation rate in example#3.

So does this make sense now? I am sure the concept is clear.

But it will take the intelligence of Raghuram Rajan to help us get it sink further deep in our mind.

Here comes the Dosa Economics…

Dosa Economics & Purchasing Power

What defines the purchasing power of a common man? Two things:

  • Amount of money in hand.
  • Strength of money in hand.

Understanding amount of money is simple. Rs.100,000 can purchase more things than Rs.100, right?

But what is strength of money?

In year 2015, INR.100 could buy perhaps 2 Kg of Apples.

In year 2018, INR.100 can buy only 1 Kg of Apples.

It means, the strength of INR has reduced in 2018, compared to 2015.

Why this happened? Because of inflation.

When strength of money reduces, it also reduces our purchasing power.

How to ensure that the purchasing power of our money keeps increasing with time?

A fair parity must be maintained between prevailing interest rates and inflation.

Dosa Economics explains this concept using the analogy of Dosa’s

Lets understand Dosa Economics with these 2 simple examples:

Example-1

  • Interest Rate: 10% per annum.
  • Inflation Rate: 9% per annum.

Suppose a person has Rs.10,000 in his pocket (year 2018).

He has two options available with him:

  1. Today Focused: He can buy 100 Nos Dosa’s @Rs.100 each (year 2018).
  2. Future Focused: He can invest Rs.10,000 to buy more Dosa’s tomorrow (in year 2019).

Investing Rs.10,000 @10% for 1 year, will increase his corpus to Rs.11,000 (year 2019).

With these Rs.11,000, he can buy 110 numbers dosa’s (11,000/100), right?

But wait, what about inflation?

He will be not be able to buy 110 no’s Sosa’s. He will buy lesser.

Due to inflation, the price of Dosa will also go up by 9%.

Rs.100 dosa in year 2018 will cost Rs.109 in 2019.

So how many Dosa’s Rs.11,000 can buy in year 2019? Almost 100.9 numbers(100 nos approx).

What does it mean?

Even after investing his money, the person can buy only ~100 numbers Dosa’s in 2019.

It means the investment could add very less value to his money.

Though the person earned a good nominal interest of 10%, but his real interest was only 1%. Why?

Because of high inflation rate (Compared to the nominal interest rate).

Real interest rate = Nominal interest rate – Rate of inflation

Real interest rate = 1% (10% – 9%).

#. Example-2

  • Interest Rate: 8.5% per annum.
  • Inflation Rate: 5.5% per annum.

Suppose a person has Rs.10,000 in his pocket (year 2018).

Investing Rs.10,000 @8.5% for 1 year, will increase his corpus to Rs.10,850 (year 2019).

In the same period, due to inflation, the price of Dosa will also go up by 5.5%.

Rs.100 Dosa in year 2018 will cost Rs.105.5 in 2019.

So how many Dosa’s Rs.10,850 can buy in year 2019?Almost 102.8 numbers (102 nos approx).

Conclusion…

What does the above 2 examples conclude?

Compare Example-1 and Example-2.

In which case the person could buy more Dosa’s.

In Example-2 the person could buy more Dosa’s. How?

The purchasing power of Rupee in Example-2 was higher than in Example-1.

How purchasing power was higher? Because of low inflation.

Lower inflation rate (compared to nominal interest rate) increases ones purchasing power faster.

In other words we can say, when inflation rate is lower compared to nominal interest rate, one can earn higher real rate of return.

The real interest rate in example-2 was higher.

Real interest rate = Nominal interest rate – Rate of inflation

Example-2 = 3% (8.5% – 5.5%).

Example-1 = 1% (10% – 9%).

Final words…

In example-1 the person earned a nominal interest rate of 10% p.a.

In example-2 the person earned a smaller nominal interest rate of 8.5% p.a

But who could one buy more number of Dosa’s? Example-2. Why?

Because the real interest rate in Example-2 was higher. See the table…

SLDescriptionExample-1Example-2
ANominal Interest Tate10%8.5%
BInflation Rate9%5.5%
CReal Interest RateA – B1%3%
DInvestment Amount in 2018 (Rs.)10,00010,000
EInvestment Corpus in 2019 (Rs.)D×(1+A)11,00010,850
FCost of Dosa in 2018 (Rs.)100100
GCost of Dosa in 2019 (Rs.)F×(1+B)109105.5
HNos of Dosas could be Purchased in 2018 (nos)D÷F100100
INo. Dosas could be Purchased in 2019 (nos)E÷G100.9102.8

People often worry when interest rates on deposits are falling.

Of course, earning higher interest rate is better.

But the only correction must must make into ones thinking is…

Always focus on real interest rate and not only on nominal interest rate.

Historical “Real Interest Rate” on 1 year FD of SBI is as follows:

YearAverage Nominal Interest Rate offered on 1Year FD by SBI (%)Average Inflation Rate in India – CPI (%)Real Interest Rate (%)Crude Oil Price ($/Barrel)*
20186.78%4.55%2.23%65.08
20176.60%2.49%4.11%50.91
20166.94%4.97%1.97%43.41
20157.71%5.88%1.83%48.87
20148.82%6.37%2.45%92.82
20138.88%10.92%-2.04%98.05
20128.90%9.30%-0.40%94.14
20118.65%8.87%-0.22%95.11
20107.17%12.11%-4.94%79.6
20096.75%10.83%-4.08%62.09
20088.37%8.32%0.05%99.75
20078.75%6.39%2.36%78.85

* Rate of Crude oil import in India has been provided just to compare it with the respective years inflation rates.

Be the first to comment

Leave a Reply

Your email address will not be published.


*