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Explained: How Repo Rate cut spurs economic activity

By Vishal S
|

New Delhi, Oct 04: The Reserve Bank of India (RBI) today lowered the Repo Rate by fifth time straight by 25 basis points and now stands at 5.15 per cent. The move assumes significance amid the slowing economy and the government doing all it can to revive it.

Indian economy's growth rate nosedived to its slowest pace in over six years. The decline in consumer demand and investment not being as much as expected are said to be two of the important factors for this slowdown.

RBI Chairman

The sectors are interconnected, in the sense that lowering of demand for one industry will also affect other businesses linked to the industry. If the Auto Sector slows down, then the companies would sell fewer vehicles, and this would impact the ancillary units that manufacture vehicle components like companies manufacturing steering, the seat covers, small nuts bolts and valves makers, automotive battery manufacturers. Because lesser the company sells, fewer vehicles will it manufacture and less will the main automobile maker buy these vehicle parts from ancillary units.

Similarly, if demand for new homes comes down, the construction will also come down, which will lead less consumption of cement, bricks, doors and windows and all the other things that are needed to furnish a house.

Repo Rate and affect on demand:

Repo Rate is the rate of interest at which the RBI lends money to banks. There are complex macroeconomic theories that explain these in terms that hardly make sense to a common person. Simply put, the government would want to lower the Repo Rate when it wants to boost economic activity. It is a way to infuse money or cash (liquidity) in the economy when there are signs of slow down. If Repo Rate comes down, then it would cost banks less to borrow from the RBI. This, in turn, allows the banks to lend in the market at a lower price without having to compromise with its own profit margin.

[RBI cuts Repo Rate by 25 basis points, GDP forecast for 2019-20 revised to 6.1 %]

    RBI transfers 1.76 lakh crores to govt to give the economy a push

    Once the lending rate of banks come down, the businesses would hesitate less to borrow and invest. After all, a business, of any kind, is about earning more money than what has been spent. A large part of what has been spent or investment would be in the form of borrowings from the bank. So, what a business or company earns should not only cover its costs on wages to the employees, raw material, process involved in getting a product or service ready for market, but also the interest it pays on the money borrowed from banks.

    Essentially, when the lending rates come down, more businesses would want to borrow and invest in the expansion of the business which in turn boosts the economic activity. This is the concept behind lending rates, repo rates and their relation with the economic activity on the ground. In reality, many other factors play a role in determining the level of economic activity.

    [Banks to pass-on Repo Rate cut benefits to customers: FM; EMIs, Auto loans to become cheaper]

    Like, if a company begins to scale up the operations just because the banks are lending at lesser rates without considering if there is even a demand in the market for its offerings, then it would be doomed. Repo Rate is one of the key factors that influence economic activity. More the economic activity, more would the jobs be created, the average incomes would go up which may increase spending. Once spending by people goes up, many sectors benefit. All this is a big economic cycle with a chain of events affecting others, but the exact magnitude of the affect of a particular move could be hard to find.

    Along with reducing Repo Rate, to make banks pass on the benefits, Finance Minister Nirmala Sitharaman in August said that banks have now agreed to pass on interest rate cuts through the MCLR reduction. Banks have also decided to launch repo rate-linked loan products, the Finance Minister stated.

    RBI had earlier said that the move was aimed at reducing the interest rate on housing and the auto rate.

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