Dosanomics: Why Higher Interest rates are not Your Friend?

19 Jul 2022  Read 268 Views

Most people work furiously to cross the boundary of being middle class to reach the goal of living comfortably. But then inflation slaps you so hard that you fall back to the same level from where you started!

Interest rate and inflation are two such things that can stress anyone within a couple of minutes. As the inflationary bar rises, so does the blood pressure of retirees and pensioners. A few years ago, Dr Rajan, the former and esteemed RBI governor of India observed a new aspect of high and low inflation named Dosanomics. Wondering what Dosanomics means? And how does it work? Read this article to find out more about the concept!

What is Dosanomics?

"The best measure of inflation is what is happening with commodity prices." - Stephen Moore.

Are you hearing the term “Dosanomics'' for the first time? If yes, then the first and foremost thing is not to go for the literal meaning as it has got nothing to do with the well-loved south-Indian dish "Dosa". It is far from that!

Dosanomics states that high-interest rates are less profitable when there is high inflation than the low-interest rates under low inflation. Raghuram Rajan first coined the term in 2016; hence it is referred to as "Dosanomics by Raghuram Rajan". 

How was it invented?

When Raghuram Rajan was serving as the governor of the RBI, he implemented many strategies. While some of them were recognized and praised, many were also criticised. In 2016, he faced a lot of criticism due to one decision. What was it?

  • Firstly, 2016 was a year of many complications. People were unhappy with the high-interest rates offered by banks due to the high inflation. At that time, the interest rate was 10%, equivalent to the inflation rate.

  • Rajan reduced the interest rate for fixed deposits from 10% to 8% when there was a decrease in inflation by 5%.

  • It became a matter of controversy because many people were living off of their FDs. This sudden shift in interest rate was unexpected. Many who had invested in FD were unhappy with the move as a lower interest rate implied a smaller payout at the end of the year.

"Earlier, we used to get 10% interest on fixed deposits. It has reduced to 8%. We don't know if we will be able to make our ends meet." Many retirees gave this remark when the news came out.

Lower interest rate: Is it good or bad?

"It's sort of like a teeter-totter. When interest rates go down, prices go up." - Bill Gross, Co-founder of PIMCO.

What is more profitable? Lower interest rates or higher interest rates? And why? 

There seems to be an inverse relationship between prices and interest rates. When interest rates go up, prices go down and vice-versa. You may think that a higher interest rate will solve your problems whenever there is high inflation. It is not entirely wrong but still far from the truth.

A lower interest rate during low inflation benefits one more than the higher rates in higher inflation. Ultimately, what you need to know is that higher interest rates will not always leave you satisfied. Sometimes, low rates of interest turn out to be more beneficial. You will understand why in the next section!

Decoding the Dosanomics meaning

Many people did not understand the concept of Dosanomics. The lack of understanding was also responsible for making people agitated against the move. In a press interview, Raghuram Rajan explained the theory behind his decision with a well-defined example. Let's take that example to clarify how interest rates and inflation are interconnected and how they affect our lives!

Scenario 1: When the interest rate is high during high inflation

There is a man, say X, who has just retired. He has saved an approximate amount of Rs.1,00,000. If he deposits a fixed amount of 10%, he will get the interest of 10,000, along with the savings making the final amount equivalent to Rs. 1,10,000.

He knows that he will be able to buy his favourite food, say dosas, in large amounts. If a dosa costs ₹50, he can buy about 2200 of them. But here's the catch! There is 10% inflation in the economy. So what happens now is that there will be an increase in the price of this delicacy. Instead of being available at ₹50, it will cost ₹55. X can afford to buy 2000 dosas.

So, the investment does not fetch him any profit.

Scenario 2: When the interest rate is low during low inflation

In the second scenario, if the inflation rate reduces to 5.5% and the interest rate is 8%. X will get 1,08,000 at the end of the year. With the extra amount, he can purchase his favourite delicacy dosa by using his interest amount. But, the economy is experiencing a low inflation rate of 5.5%, due to which the price of the item increases at a lower rate. It makes the cost of dosa 52.75. Now, X can buy 2048 dosas.

You must be thinking, where is the "Dosanomics" in these calculations, right?

You can see that when there is a high inflation rate, X can buy up to 2000 dosas, but when there is low inflation, he can get 2048 dosas. What does it conclude?

You must have realised that the example of low inflation with a low-interest rate gives a high profit to the saver. X can buy more of his favourite delicacy when both interest rates and inflation rates are low when compared to the high-interest rates during high inflation.

This is what Dosanomics by Raghuram Rajan means. The retirees get a profit of 2.5%. 

However, did you notice that even when the inflation rate dropped, the price of dosa still increased? Why is that? 

In developed countries, technology continues to advance, and salaries and wages for the workers and staff increase to aid them in this high-priced world. To serve staff with high wages, one needs to find a way to earn more profit from somewhere, which raises another question, do labour costs have to increase?

A dollar in the 1950s is worth the same as USD 12.37 in 2022.

Why do labour costs have to rise?

Labour costs go up due to the relation between the Balassa-Samuelson effect and Dosanomics. An economy has many sectors. Specific sectors experience rapid growth while others are left behind. But people would like to engage in those sectors where they can also get a high wage and productivity. 

But it has a downside; as technology evolves, machines replace labour. Workers also leave their jobs to hunt for alternate opportunities. It causes a non-uniform distribution of work. It becomes crucial to increase their wages routinely to keep the employees performing.

Writer's Opinion

Is there a change in the dosa economy? Can one change this situation? If not, then why not? If yes, then how? The Dosanomics by Raghuram Rajan may not be as crystal clear as he says it to be. Even with the low inflation, the price of products, especially edibles, does not simply drop or fall; instead, they increase too. 

When a food item is sold at a higher price than before, it does not return to its previous price and only keeps rising. In simple words, Dosanomics by Raghuram Rajan states how things should be, not how they are! 

The Bottom Line 

Inflation is a serial killer in today's economy if one forgets to acknowledge it. It puts one in a delusion that the interest generated from their fixed deposits will assist them in the upcoming time, but they disregard the fact entirely that inflation is touching new peaks each day.

While everyone is chasing the high-interest rates, Dosanomics by Raghuram Rajan showed a different perspective of how one can benefit from the low-interest rates. They are not always bad, especially when inflation is low, as explained by Dosanomics.

Now that we've reached the end tell us what you think about the concept of Dosanomics in the comments, and share the article with your friends!

About the Author: Deb P Samaddar | 248 Post(s)

Deb is a keen learner and eager to learn about the finance world. He is that person who would never stop talking, but my oh my, the words he uses, are not something a normal human would in a regular conversation. While the conversations are well, interesting, the write-ups are faultless. With an increased proclivity towards tech and language, he aims to capitalise on his interests as a content writer at Finology.

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