The US, Euro zone, Japan and some of the most developed economies of the world have been through a phase of extremely low interest rates. These nations lowered interest rates for a prolonged period to boost demand and spur economic growth.
Technically speaking, low interest rates over prolonged periods provide cheap credit and increase the money supply in the economy and logically this should spur inflation. However, this has not happened and strangely enough, low interest rates and low inflationary rates have been strange bedfellows in these nations for over a decade.
To understand this relationship, let’s study the causes of inflation. Inflation can be categorized into two categories, ‘cost push’ and ‘demand pull’. Cost push inflation occurs when costs of inputs rises and leads to higher prices of consumption products. Hardened global crude prices are a common cost push factor. Demand pull inflation occurs, when excess demand in the economy or euphemistically put, excess money chasing les goods, pulls prices up.
Low interest rates leading to cheap credit and excess money supply should have resulted in demand pull inflation. However, this has not been the case.
The chief reason being cited for this anomalous coexistence is nothing but the mantra called globalization. Had the economies functioned in isolation like in the pre-global period, low interest rates would certainly have sparked inflation. However, the two low cost production bases,
China and India have contributed immensely to keep prices of goods down and have allowed the paradoxical coexistence of low inflation and low interest rates.
China’s major contribution has been the lowering of production costs of manufactured products, while India has helped reduce the costs in the service industry, with a large number of business processes being outsourced to India.
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