is because it is low today, and thus would mean low policy rates. this is short - sighted reasoning for when commodity prices and global inflation picks up, wpi could well exceed cpi. there is, however, a more subtle argument ; the real interest rate is the difference between the interest rate a borrower pays and inflation – it is the true cost of borrowing in terms of goods like widgets or dosas. if policy interest rates are set to control cpi, they may be too high for manufacturers who see their product prices appreciating only at the wpi rate. i am sympathetic to the argument, but i also think the concern is overblown. even if manufacturers do not have much pricing power because of global competition, their commodity suppliers have even less. so a metal producer benefits from the fall in coal and ore prices, even though they may not get as high a realization on metal sales as in the past. the true measure of inflation for them is the inflation in their profits, which is likely significantly greater than suggested by wpi. a second error that is made is to attribute all components of the interest rate paid by the borrower to monetary policy. for heavily indebted borrowers, however, a large component of the interest rate they pay is the credit risk premium banks charge for the risk they may not get repaid. this credit risk premium is largely independent of where the rbi sets its policy rate. so when someone berates us because heavily indebted industrialists borrow at 14 % interest with wpi at 0. 5 %, they make two important errors in saying the real interest rate is 13. 5 %. first, 7. 5 % is the credit spread, and would not be significantly lower if we cut the policy rate ( at 6. 5 % today ) by another 100 basis points. second, the inflation that matters to the industrialist is not the 0. 5 % at which their output prices are inflating, but the 4 % at which their profits are inflating ( because costs are falling at 5 % annually ). the real risk free interest rate they experience is 2. 5 %, a little higher than elsewhere in the world, but not the most significant factor standing in the way of investment. far more useful in lowering borrowing rates is to improve lending institutions and borrower behavior to bring down the credit risk premium, than to try and push the rbi to lower rates unduly. the policy rate in effect plays a

where in the single digits the precise threshold lies. 2 the inflation target nevertheless, given the limited evidence, why do most countries set their inflation goal in the low single digits – 2 to 5 percent rather than 7 to 10 percent? three reasons come to mind. first, even if inflation is at a moderate level that does not hurt overall growth, the consequences of inflation are not evenly distributed. while higher inflation might help a rich, highly indebted, industrialist because his debt comes down relative to sales revenues, it hurts the poor daily wage worker, whose wage is not indexed to inflation. 3 second, higher inflation is more variable. this raises the chance of breaching any given range around the target if it is set at a higher level. to the extent that a higher target is closer to the threshold, this makes it more likely the country will exceed the threshold and experience lower growth. third, inflation could feed on itself at higher levels – the higher the target, the more chances of entering regions where inflation spirals upwards. the received wisdom in monetary economics today is therefore that a central bank serves the economy and the cause of growth best by keeping inflation low and stable around the target it is given by the government. this contrasts with the earlier prevailing view in economics that by pumping up demand through dramatic interest rate cuts, the central bank could generate sustained growth, albeit with some inflation. that view proved hopelessly optimistic about the powers of the central bank. there is indeed a short run trade - off between inflation and growth. in layman ’ s terms, if the central bank cuts the interest rate by 100 basis points today, and banks pass it on, then demand will pick up and we could get stronger growth for a while, especially if economic players are surprised. the stock market may shoot up for a few days. but you can fool all of the people only some of the time. if the economy is producing at potential, we would quickly see shortages and a sharp rise in inflation. people will also start expecting the central bank to disregard inflation ( that is, be hopelessly dovish according to the bird analogies that abound ) and embed high inflationary expectations into their decisions, including their demand for higher wages. if contrary to expectations, the central bank is committed to keeping inflation under control, it may then be forced to raise interest rates substantially to for example, bruno and easterly ( 1995 ) suggest 40 percent as a danger point, beyond which increases in inflation are very likely