Sunday, July 14, 2013

What is "Cheap Money Trap"? and What are all its ramifications?

Cheap Money Trap:

In an economy, to boost the growth the policy makers lower the interest rate of the central bank. So that the entrepreneurs would get money for lower rate and they produce goods and sell it. Thus the economy will grow. But in real world this have not been worked that perfectly.

During 'Great Depression' (1930), UK govt tried this cheap money regime. They targeted the entrepreneurs, but the people took advantage of cheap money and borrowed more loans for housing. So, less economic transactions lead to less growth. Thus, the cheap money regime was a largely unsuccessful one.

This cheap money policy becomes a trap, when the fear of depression/recession tend to keep the rates low always. This is like economy becomes addicted to 'cheap money'. If we try to stop the drug (raise interest rate), the sick guy (economy) may collapse and the safe way to do is unknown. Thus the "cheap money trap".

Ramifications:

As for as the rich countries are concerned, their problem would be like "If we raise the interest rate, will the economy collapse?". But, sooner or later, when the situation is most favorable they will surely raise the interest rate.

With reference to India, we are now(2013) largely depending on the foreign investments. Whenever we receive USD in any form (FII or FDI), we become happy that our reserve raises. But actually we are accumulating debt. During cheap money regime the foreign investor gets easy money and he would want to get more returns out of it. So he invests in India. But when the cheap money supply stops, the foreign investment flow also stops. In fact it would get reverse and investment flows out of the country (i.e., India). This effect would destabilize our economy and lead to another BoP crisis. The possible way out from these difficulty (for India) is to strengthen the domestic Industries. Because, only a competent domestic industry will ensure the export earnings.



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