Dosa Economics is an economic theory coined by ex-RBI governor Raghuram Rajan explaining how inflation impacts the principal amount of their bank account negatively as a “silent killer” and how even with high-interest rates on fixed deposits they can end up with less purchasing power than they would have with low fixed deposit interest rates (given that the inflation is also low when the FD interest rates are low).
What is Inflation?
Inflation is a situation when the prices of commodities rise due to the high purchasing power of the people of a country which takes place when there is excessive money in the market.
Example of Dosa Economics
A numerical example of this theory as given by Raghuram Rajan himself was that suppose a person has Rs.100000 in his bank account and a Dosa costs Rs. 50 then, he can buy 2000 Dosas with the money he has. Now, let’s discuss the first situation where the interest on the FD is high but the rate of inflation is also high. Suppose that he put his money into an FD with a 10% interest rate but the rate of inflation is also at 10%. In the given scenario, he will have to pay Rs. 55 for a Dosa as the price of the Dosa is increased by 10%. Additionally, with the interest earned by him at a 10% rate would be Rs.10000.Thus, he will be able to buy 182 Dosas more.
Another situation would be of a low-interest rate on FD and low inflation. Suppose that he put his money into an FD with an 8% interest rate and inflation is at 5.5%, he will be able to buy 152 Dosas when the Dosa is worth Rs. 52.75.
Subsequently, the first situation seems more profitable for the investor as he can buy 182 Dosas with the interest earned compared to only 152 Dosas in the second scenario of low inflation.
We are only considering the purchasing power with the interest earned till now. Let’s look at what would happen to the principal. In the first scenario, the investor will be able to buy 1818 Dosas at Rs.55/serving with the Rs.100000 principal that he had invested. Now, in the second scenario of low inflation, the investor will be able to buy 1896 Dosas at Rs.52.75/serving with his principal. Here, the purchasing power of the investor at low inflation is higher.
Total number of Dosas at high inflation and high-interest rate=1818+182= 2000 Dosas
Total number of Dosas at low inflation and low-interest rate= 1896+152= 2048 Dosas
As 2048 Dosas > 2000 Dosas, low inflation and low-interest rate are better than high inflation and high-interest rate.
Why was this theory needed?
This theory was needed to explain to the pensioners who were worried about low-interest rates on FD, how inflation was reducing the ‘real value’ or purchasing power of their principal even if they received high-interest rates on the Fixed Deposits (a common choice for investing among pensioners as it involves very low risk) and how low-interest rates on FD would be better for them if the inflation were also low. Back then, Raghuram Rajan was the RBI governor and he used Dosas as an example of a commodity to show purchasing power in this theory, so it is now known as Dosa Economics.
When was it implemented by Raghuram Rajan?
Raghuram Rajan was the RBI governor from 2013 to 2016. Now, to understand how he implemented Dosa Economics we have to know what Repo Rate is.
Repo Rate is the rate at which the commercial banks borrow money from the RBI. Now, lower the Repo Rate, lower the interest rate on Fixed Deposits as now the commercial banks can borrow money from the RBI at a lower cost so they will not be dependent on the common people to raise funds by using Fixed Deposits as a way of doing so. As the banks won’t be dependent on the public, they can set low-interest rates on FD as they don’t need customers to have an FD as much as they did when borrowing from the RBI was costly due to high Repo Rate.
It was implemented in 2016, Rajan dropped the Repo Rate to 6.50% (-1.50%) and the interest on the FD also went down to 6.90% (-1.10%) which made a panic situation for the pensioners as stated above. But, the catch here is that inflation also dropped from 5.87% to 4.94% in 2016 and the Net Return (FD rate – inflation rate) was at 1.96%.
Did it work?
Let’s look at years with high FD interest rates 2011, 2012 and 2013 when the FD rates were 9.25%, 9.20% and 9.00% respectively. In 2011 Net Return was 0.39% followed by -0.11% and -1.91% in 2012 and 2013. Here, FD returns couldn’t beat inflation in 2 of the given 3 years and when they did beat it in 2011, 2016 was almost 5 times better. Raghuram Rajan gradually decreased the FD rates from 9.00% to 6.90% in a span of 4 years and was successful in beating inflation in all the years except his first year as an RBI governor.
The GDP growth rates also started to rise when Raghuram Rajan was in the office and crossed 8.00% twice in his 4 years of tenure.
All investors should think about the rate of return but not so much that they neglect the impact of inflation on their principal. Investors should focus more on the Net Returns or the Real Returns that they will be getting on investment as an investment with a high rate of return which would not increase the purchasing power of the investor is not desirable. Only positive Real Returns can increase the purchasing power of an investor. Dosa Economics is a very important theory not only for pensioners investing in an FD but for all the investors.
It will be safe to say that Dosa Economics was a success and it reduced inflation.
Manish; Dosa Economics: How Falling Interest Rates on Deposits is not always bad?; https://getmoneyrich.com/dosa-economics/