RBI INTERVENES AGAINST COVID-19

On Friday, March 27, India’s Central Bank, The Reserve Bank of India reduced the Repo Rate and Reverse Repo Rate in order to tackle the economic slowdown India is facing due to the coronavirus. India has been under a total lock down and only essential services are open to consumers, this has led to production of a lot of goods and services being put at a standstill since workers cannot travel to their workplace, leading to a shortage of goods and services

forcing many retailers to sell goods at higher prices.

The repo rate is the rate at which the commercial banks borrow money from the central bank. The reverse repo rate is the rate at which the central banks borrow money from the commercial banks, commercial banks may park their excess money there. Both the repo and reverse repo rate are a part of the monetary policy which controls the interest rate and money supply in the

country.

The new repo rate is set at 4.40% and this has been the lowest in the history of the bank! Reducing the repo rate leads to commercial banks borrowing more money from the central bank and may even lead to banks to reduce the interest rates at which they let consumers borrow. This encourages consumers to borrow and spend more money and hence increase the aggregate demand in the economy. It also encourages producers to borrow money and invest into better technologies leading to increasing the aggregate supply in the economy.

The reverse repo rate which has been reduced to 3% leads to discouraging banks to park their money with the central bank because the interest rate is low and hence instead of parking the excess money, banks may choose to invest in other businesses to expect better returns, hence injecting more money in the economy.

Since the reduction of these rates may increase both aggregate demand and supply, it will help reduce unemployment in the country which has been at its highest in 10 years. The RBI also predicted a slowdown in economic growth however, these policies may lead to economic

growth and save India from going into recession. Hence these steps seem necessary and vital to save the economy from sinking. However, the change in aggregate supply and demand should match, If the increase in demand is more than the increase in supply then inflation would increase while if supply exceeds demand then disinflation will take place and incentives for producers fall.

Once the production of goods starts the demand for goods will be very high since most consumers would have exhausted their reserves and the aggregate supply will be very low since firms who have halted production will have to restart production. This may lead to high levels of inflation which can be harmful for the economy. However the reduction in repo rate may help firms to borrow more and invest in better technology which will lead to an increase in aggregate supply.

However, there are short term effects of reducing the repo rate and the reverse repo rate together, this will lead to a heavy injection of money supply. As India is currently in a moratorium there is stagflation, but the demand for the goods still exists. Furthermore, by increasing the money supply in the economy the purchasing power of people is more likely to increase resulting in aggregate demand being greater than aggregate supply, and hence leading to galloping or walking inflation, which can cause the exchange rate of India to fall, which will make imports more expensive. Knowing that India is a country which heavily based imports, a falling exchange rate can lead to high cost of production for firms and hence, lead to reduced competitiveness in the global market or shutdown, which will further lead to unemployment in the economy with falling GDP.

Image courtesy- Rueters

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