How can high rate of inflation lower the cost of loan?

SukanyaSharma

| 7 month(s) ago

Suraj_Chrasiya

10 comments

Fastandcuriouss .

commented 7 month(s) ago

Higher Interest rate leads to lower demand in an economy and thus leads to low inflation similarly when lower cost of borrowing means more loans ->money supply increases so it will lead to inflation

SukanyaSharma,

Chanakya .

commented 7 month(s) ago

Suppose you took a loan of ₹100 a month ago at 10% interest per month to produce a product worth ₹150 in market. High inflation means that by the time you sell the product it's market price will be more than ₹150, say ₹160. So that ₹100+₹10 will hurt you lesser when you earn ₹160 than when you earned ₹150. The ₹110 you return to lender is worth lesser than what it would have been without inflation. This is how inflation makes loans cheaper, debtors benefit and lenders suffer

TheNotorious,SukanyaSharma

SukanyaSharma .

commented 7 month(s) ago

@Chanakya Got it! Thank you so much!

Chanakya,

SukanyaSharma .

commented 7 month(s) ago

@Fastandcuriouss Thank you!!

Fastandcuriouss,

TheNotorious .

commented 7 month(s) ago

Chanakyasaid
Suppose you took a loan of ₹100 a month ago at 10% interest per month to produce a product worth ₹150 in market. High inflation means that by the time you sell the product it's market price will be more than ₹150, say ₹160. So that ₹100+₹10 will hurt you lesser when you earn ₹160 than when you earned ₹150. The ₹110 you return to lender is worth lesser than what it would have been without inflation. This is how inflation makes loans cheaper, debtors benefit and lenders suffer

Hey bro.

Glad to see you active here again, that too after a long span of time.

You gave a very good example and I am considering it from demand side POV as we are the ones taking a loan.

Now, trying to substantiate from a supply side POV, let me know if my line of thought stands correct or not.

It is said that inflation erodes the value of money at hand, so people might consider depositing their money in banks to hedge out the inflationary risks. Now as the banks have got more deposits, simultaneously, their loan creating capacity also increases as a result of increase in the deposits.

Due to this increase in loan creating capacity, they may decide to lower the interest rates that are being charged on the newly created loans(economies of scale at play).

And hence, the initial high inflation in the economy ultimately lead to low borrowing cost in terms of lower interest rates charged by the banks.

Does this supply side substantiation stand correct? Ya fir mai raita faila diya? 🥲

Chanakya,ThePrince

Chanakya .

commented 7 month(s) ago

@TheNotorious yes bhai your reasoning is accurate💯.in practice, Banks don't always have to lower the interest rate since inflation reduces the cost of borrowing itself, so that creates additional demand for loans. Lowering interest rates would mean adding a layer of icing on another layer of icing, makes the cake too sweet. Economies of scale would work only if loans are not defaulted and lowering interest rate could encourage riskier loan propositions. So in practice banks usually don't lower interest rates .

But this does bring us closer to understanding why govt tries to raise repo rate ( and indirectly interest rate) to bring inflation under control

TheNotorious,