During a lecture at National Council of Applied Economic Research (NCAER) in New Delhi, Mr. Raghuram Rajan explained the inflation effect with an example of Dosa Economics. I thought this was a simple way to explain you about the inflation.
Before proceeding further, let us understand the meaning of nominal interest rate and the real rate of return.
# Nominal Interest Rate–
It is the interest rate generated by your investment before adjusting the tax effect, inflation rate or investment expenses. Let us say you invested Rs.1,00,000 in a one year FD for the interest rate of 9%. This is nothing but 9% nominal interest rate.
You are not bothering about the taxation or inflation attached to this income.
# Real Rate of Return–
It is the interest rate generated by your investment after adjusting for inflation. In simple term, let us say you invested Rs.1,00,000 in a one year FD for the interest rate of 9%. Assume for that same period, the inflation rate as 7%. Then your real rate of return is just 2% (9%-7%).
Falling FD rates and falling inflation rate
Now the biggest concern for all of us mainly the retirees who depend on such fixed instrument is, falling FD rates. FD rates, postal savings schemes rates fell so drastically that we all searching for the options where we get risk-free best returns.
But whether we observed why there is a fall in an interest rate? It is because of falling inflation rate. RBI lowers the interest rate and banks following the same. Whether it is on your FD rates or on your loans, an effect is definitely a falling trend.
What is Dosa Economics?
It is nothing but an example given by Mr.Raghuram Ranjan about explaining of how lower inflation is good even though fall in your FD rates. Hence, no need to worry. For that, he took the example of dosas as a purchasing item.
Let us take the same example to understand this concept. Mr.X a retiree want to buy Dosas of Rs.1,00,000. The cost of dosa is Rs.50. Therefore, he can buy 2,000 dosas in total.
However, Mr.X wants his principal intact and wants to buy dosas from the amount he will get by depositing the money in bank FD. Let us say he deposited this Rs.1,00,000 in an FD which fetches him an interest rate of 10%. So at the year end, he will earn Rs.10,000 from this investment and also get back his principal amount.
But assume due to high inflation the rate of dosas also raised to 10% means from earlier Rs.50 to Rs.55. Therefore, he can buy 182 dosas and also he will get back the Rs.1,00,000 deposited amount.
Next year, he will invest the same Rs.1,00,000 in a bank FD where the interest rate falls to 8% due to fall in an inflation rate. This time, the inflation rate also falls to 5.5%. So dosas rate now is at Rs.52.75. After a year, he will get Rs.8,000 as an interest and Rs.1,00,000 principal amount. From this Rs.8,000 interest amount now he can buy only 152 dosas.
Definitely due to the fall in interest rate, his buying capacity dropped from 182 dosas to 152. Therefore, even though the inflation dropped, he doesn’t get benefitted as return on his investment also dropped.
Considering this aspect, we all believe that falling interest on our FD rates a dangerous sign. However, wait…
At the time of high inflation rate after a year of deposit, he will get back Rs.1,10,000 in total (Rs.1,00,000 principal and Rs.10,000 interest). At the rate of Rs.55 of each dosa he can buy 2,000 dosas in total.
However, after the fall of inflation and interest rate, he will get Rs.1,08,0000 from his investment (Rs.1,00,000 principal and Rs.8,000 interest). At the rate of Rs.52.75 (dosas price also fallen as inflation came down), he can buy 2047 dosas.
In reality, during the falling inflation rate period, he can buy 47 more dosas from his principal and interest rate than the rise in inflation and FD rates.
I tried to explain the same from below image.
Now it is clear that if we just consider the nominal rate of return, then definitely it hurts all of us. However, we forget that fall in interest rate is due to fall in an inflation rate. This leads to same real return. The problem is the way we all look at returns on our investments.
Therefore, the best way to judge your return is always considering the inflation rate or in terms of real return. Hope this concept cleared the doubts of many.