Interest rate cuts will encourage promoters to promote new ventures and existing entrepreneurs to invest more in business, because financing these new ventures and expansion projects will become cheaper.
A fall in interest rates will increase the profitability of all businesses and hence will provide impetus to the Stock Market as well. In fact, such high interest rates make it difficult for Indian companies to compete with their foreign counterparts who can borrow funds from their home countries at 1% or 2% interest
An interest rate cut might just give a push to India’s growth rate.
But why is Mr Rajan against it?
For this you need to understand the relationship between interest rate and inflation. The following relationship is known as the Fisher equation:
where,
i is the nominal interest rate
r is the real interest rate
Pi is the inflation
Interest rate has to be more than the inflation rate, otherwise investors do not earn any real returns from their investment. With such a high inflation in the country, RBI had to keep rates high.
But now that inflation has suddenly come close to 0(not actually but yes it has been substantially low), the Modi government wants RBI to reduce the interest rates.
So why is Mr Rajan not doing that?
Because the fall in inflation is because of external factors (fall in international crude oil prices or whatever else has caused this fall), not because the factors causing inflation have been eliminated(like internal factors of agricultural product prices). Meaning, the inflation can go back up, RBI can’t be sure.
So, Mr Rajan is just being cautious and he would not reduce the rates till the inflation REMAINS low for some more time.