Dosa Economics

Simple explanation of Inflation vs Interest
” Dosa Economics” by RBI Governor



Reserve Bank governor Raghuram Rajan today indulged in ” Dosa economics” to drive home the point that low deposit rate coupled with low inflation is better than high rates with high prices.
He cited the example of a retiree who had written to Rajan saying, “I used to get 10 per cent earlier on a 1-year fixed deposit, now I barely get 8 per cent….please tell banks to pay me more else I won’t be able to make ends meet”.
“The truth is that the retiree is getting more today but he does not realise it, because he is focusing only on the nominal interest (8 per cent) he gets and not on the underlying inflation which has come down even more sharply, from about 10 per cent to 5.5 per cent,” Rajan said while delivering the C.D. Deshmukh lecture at NCAER in New Delhi today.
 The RBI governor has, so far, cut the benchmark repo rate by 125 basis points and this has led to banks bringing down their deposit rates, thus affecting retirees who depend on interest income.
To explain his point, Rajan took an imaginary example of a pensioner with a savings of Rs 1 lakh who earns an interest rate of 10 per cent and wants to buy dosas that cost Rs 50 a piece. The RBI governor assumes inflation to be 10 per cent.
“He could buy 2,000 dosas with the money today, but he wants more by investing. At 10 per cent interest, he gets Rs 10,000 after one year plus his principal,” Rajan argued.
With dosa prices going up by 10 per cent to Rs 55, he can buy 182 dosas approximately with the Rs 10,000 interest. However, with his principle amount the pensioner can now buy 1818 dosas.
Rajan then takes another situation when the deposit rate is 8 per cent and inflation rate is 5.5 per cent.
Though the retiree earns Rs 8,000 as interest, with dosa prices going up by 5.5 per cent (each dosa costs Rs 52.75) he can now buy only 152 dosas. His principle this time will buy him 1896 dosas.
According to Rajan, the pensioner can quickly come to the conclusion that with lower interest payments, he is getting less.
“But wait a minute. Remember, he gets his principal back also and that too has to be adjusted for inflation. In the high inflation period, it was worth 1,818 dosas. In the low inflation period, it is worth 1,896 dosas. So in the high inflation period, principal plus interest are worth 2,000 dosas together, while in the low inflation period it is worth 2,048 dosas. He is about 2.5 per cent better off in the low inflation period in terms of dosas,” Rajan concluded.

Admitting that this was a long winded way of stating the fact that high inflation hurts, Rajan said “inflation is the silent killer because it eats into pensioners’ principal, even while they are deluded by high nominal interest rates into thinking they are getting an adequate return”.