Were you tempted when you first saw the word “Dosa” in the title? Perhaps, it was just me. ‘Dosa economics’ is a term coined by ex-RBI governor Raghuram Rajan. He used the Dosa, a very popular South Indian delicacy, to help convey a complicated and misunderstood concept in economics in a manner that facilitates clarity and understanding.
The concept of ‘Dosa economics’ was born to explain the adverse effects of loss of the purchasing power of currency on investments and fixed deposits. To comprehend this, we must first understand the concept of the ‘time value’ of money. The concept essentially states that the valuation of money we hold at the moment is more than its valuation in the foreseeable future, say 10 months. This is because of inflation – the mechanism by which the general price level in an economy rises, thus reducing the purchasing power of the currency. For example, if right now I could purchase ten apples with ₹100, in one year I can purchase only eight apples with ₹100. Hence, what we have now is worth more than an identical sum we could hold in the future due to a decline in its earning capacity. This fundamental financial principle emphasizes the importance of money held at present over money that could be accumulated unless it has the potential to earn interests.
While inflation can disrupt the purchasing power of our currency, it is important to maintain a certain level of it, for both low and high levels of inflation harm the health of an economy. For this purpose, the Reserve Bank of India (RBI) uses a tool known as the ‘Repo rate’. The repo rate is the rate of interest imposed on the loans offered by the RBI to Indian commercial banks, which in turn affects the market rate of interest or the rate at which banks lend loans to the general public. The repo rate directly affects the market rate of interest, so an increase in one pushes the other up and vice-versa. If the rate of inflation in the economy is high, the RBI seeks to curtail money supply as the inflationary pressure could decrease its value. Hence, the RBI increases the repo rate, which increases the market rate. Consumers will be less inclined to borrow loans from banks, reducing the credit generated in the economy.
How much is a Dosa worth?
Rajan used the concept of ‘Dosa economics’ to break-down a complicated concept to pensioners and investors, who were worried about the falling rate of interest and its effect on their returns; for many, it was their primary source of income. But, according to Rajan, the falling rate of interest would actually help them. He used the following example:
“Say the pensioner wants to buy dosas and at the beginning of the period, they cost ₹50 per dosa. Let us say he has savings of ₹1,00,000. He could buy 2,000 dosas with the money today, but he wants more by investing. At 10% interest, he gets ₹10,000 after one year plus his principal. With dosas having gone up by 10% to ₹55, he can buy 182 dosas approximately with the ₹10,000 interest.” If, however, the rate of interest drops to 8%, the pensioner will receive ₹8,000. The dosas, going up by 5.2%, will cost ₹52.75 a piece. Meaning, he will now be able to buy 152 dosas. “So the pensioner seems vindicated: with lower interest payments, he can now buy less”, said Rajan.
He, then, reminds investors of the principal amount, which too must be adjusted for inflation. “In the high inflation period, it was worth 1,818 dosas, in the low inflation period, it is worth 1,896 dosas. So in the high inflation period, principal plus interest are worth 2,000 dosas together, while in the low inflation period it is worth 2,048 dosas. He is about 2.5% better off in the low inflation period in terms of dosas”, Rajan concluded.
Breaking it down
Before we comprehend this example, we must understand two things: –
- Nominal rate of return: the rate of return on an investment or deposit which has been specified by your bank. For example, if the bank tells you that the rate of return on your deposit is 6%, the nominal rate is 6%.
- Net return/ real rate of interest: the rate of return adjusted with the level of inflation.
The objective behind crafting this analogy was to look beyond the nominal rate of return and to discern the impact of inflation on our investments. Let us assume that in the above example, the pensioner has two markets to invest his money in to earn more income; one is a market with a high interest rate and the other has a relatively lower rate of interest. With some common sense, one would immediately say that a market with a high rate of interest is better as it facilitates high returns. But here lies the fallacy. After factoring the rate of inflation, one would see that the returns in the market with a lower rate are higher than its counterpart.
People often worry about falling interest rates and yes, lower rates are worrisome. But it is only falling real interest rates that are concerning. In most cases, investors and pensioners focus only on falling nominal rates of return. The statistics of the real rates of interest, which actually indicate whether the investment is generating positive yields or not, are ignored. Hence, one key takeaway from this concept is to focus on the real rate of return.
But another, and more important, takeaway from Rajan and his ‘Dosa economics’ is the importance of the subject matter in our everyday lives. Economics is something I fondly like to describe as the science of choices. It is that body of knowledge that governs our choices, and its fundamental principles can be so evidently seen even in the simplest, most trivial acts in life such as the dosa. Hence, what I request of you, as a reader, is to not dismiss economics as a subject of less import. It is witnessed in anything and everything we do.
Shreedaya is a high-school student from Chennai studying humanities with mathematics. She is extremely passionate about economic and social issues and dreams of becoming an economist someday