The Hindu Business Line : Interest rate determination

There is no separate way for determining interest rates in underdeveloped and developed countries. Interest rates, in most modern economies, are a function of the inflation rate because they are fundamental in the fight against inflationary forces. The higher the inflation rate, the higher the interest rate, and vice-versa. The key difference between interest rates in developing and developed countries is that rates tend to be much higher in the former than in the latter because, usually, inflation rates are lower in developed countries.

There is no special theory about it for India. It’s the same as everywhere else.

Pricey oil

I need a deeper understanding of the impact of crude oil on the economy of a country.

Lissim Nizar

There is one fact of life. For good or for bad, economies need oil to run smoothly. Smooth supply oil was taken for granted till the 1970s, and the prices were also very low. The OPEC decision to impose controls led to crude prices shooting up. This was when economies across the world realised how dependent they were on oil. Most economies took a beating, and countries such as the US took many years to recover from the crisis.

Over time, prices did fall again because the OPEC cartel failed to work. But the Gulf war during the beginning of the 1990s temporarily pushed up prices. And in mid-2000 there was a spike in oil prices. However, the fundamental difference between the present ‘oil shock’ and the previous ones is that this time it’s more demand-driven, while earlier it was supply-related. In other words, there has been a fundamental shift in the oil market.

The previous supply-shocks were artificial in the sense that the oil countries imposed quotas on production, causing prices to go up. This time, however, oil production has been at fairly high levels but demand for oil by India and China is making prices skyrocket. This means that prices now have a much higher floor. It is unlikely that oil will ever go back to $30 levels seen a few years ago. The new floor is likely to be in the mid-to-high $50s.

The other difference this time around is the presence of hedge funds which have bought oil futures in massive quantities, pushing up crude prices. Though it is easy to blame hedge funds for the price rise, they are a mere reflection of current fundamentals and outlook. Investment bank Goldman Sachs has reported that oil is likely to touch $100 by the end of the year and this is very likely, given the way things are going.

However, adjusted for inflation, current oil prices are much lower than in the 1970s. In today’s prices, 1970s oil would be more than $100 a barrel.

SUNIL RONGALA

(The author is an economist. The views are personal. Send in your queries on economics to Whackonomics@gmail.com)

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