Macro Economics End Term Project

Topic: An analysis of the effect of changes in

Repo-Rate on Macroeconomic Variables

Prepared by:
Arjun Veer Singh : PGP10010
Sudhir Pawar .: PGP10056
Tanvi Rane : PGP10041
Pratik Sharma ..: PGP10039
Pratik Rungta ..: PGP10038
Suraj Chaudhary : PGP10058
Siddharth Pal : PGP10051
 Contents

S.No. Topic Page No.

1. Executive Summary 3
2. Introduction 4
3. Effect on GDP 6
4. Effect on Inflation 7
5. Effect on Exchange Rate 8
6. Effect on borrower’s EMI 9
7. Recommendations 10
8. Bibliography 10

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 Executive Summary

Monetary policy is the macroeconomic policy laid down by the RBI. It involves management
of money supply and interest rate and is the demand side economic policy used by our central
bank to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
Changing Repo-rate is one of the instruments that the RBI uses to achieve these objectives. We
have seen a reduction of 110 bps in repo rate since February 2019.
Repo Rate and GDP of a country are inversely related. That is, if repo rate decreases, the GDP
of a country increases. This is because of increase in money supply in the economy leading to
increase in demand of goods in economy. Thus resulting in increase in GDP.
Repo Rate and inflation are inversely related. That is a decrease in Repo Rate leads to increase
inflation. Both the economic factor are closely related to each other and Repo-rate has a great
influence over the inflation rate.
Repo Rate and foreign exchange rate also share an inverse relationship between them. An
increase in Repo rate leads to strengthening of domestic currency and thus leading to falling
exchange rate due to strengthening of domestic currency.

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 Introduction

Liquidity Adjustment Facility

Liquidity Adjustment Facility (LAF) is the principle instrument of the Reserve Bank of India
for modulating liquidity and transmitting interest rate signals. LAF is used to help banks in
adjusting the day-to-day mismatches in liquidity.
Based on recommendations of the Second Narsimham Committee, 1988, an interim LAF was
introduced in 1999 to provide a ceiling, and the fixed rate repos were provided to floor for
money market rates. LAF was introduced on June 2000. LAF includes repo and reverse repo
operations. Repo operations inject liquidity into the economy, whereas reverse repo rate
operations absorb the liquidity in the marketplace.

Repo (Repurchase) Rate

Repo rate is the rate at which the central bank of a country (Reserve Bank of India, in case of
India) lends money to commercial banks in the event of any shortfall of funds. The monetary
authorities use this tool to control inflation level, control liquidity, and control money supply
within the country. The repo rate in India is fixed and monitored by the Reserve Bank of India.
In case of a shortage of funds or due to some statutory measures, the liquidity within an
economy decreases. The banks borrow funds from RBI by selling government securities with
a legal agreement to repurchase the securities traded on a given date at a predetermined price.
The rate of interest charged by RBI while they repurchase the securities is nothing but the repo
rate. As the repo rates decrease, the banks tend to sell securities back to the government in
return for cash. Thus, increasing the money supply within the economy. Conversely, by
increasing repo rates, central banks can effectively decrease the money supply by discouraging
banks from reselling these securities.

Components of a Repo Transaction

Preventing Economy “squeezes” – The Central bank increases or decreases the Repo rate
depending on the inflation. Thus, it controls economy by keeping inflation in the limit.
Short-Term Borrowing – RBI lends money for a short period, maximum being an overnight
post which the banks buy back their securities deposited at a predetermined price.
Collaterals & Securities – RBI accepts collateral in the form of gold, bonds, etc.
Cash Reserve (or) Liquidity – Banks borrow money from RBI to maintain liquidity or cash
reserve as a precautionary measure

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Reverse Repo Rate
Repo rate is the rate at which the central bank of a country (Reserve Bank of India, in case of
India) borrows money from commercial banks within the country. It is a monetary policy
instrument used to control the money supply in the country.
An increase in reverse repo rate will encourage commercial banks to invest their funds with
the RBI as they will get more incentives, thereby decreasing the supply of money in the market.
Lowering the reverse repo rate will discourage banks from investing funds into RBI, thus
increasing the liquidity.

Types of Repo rates

Overnight Repo Rate
The overnight repo rate is available for the commercial banks to adjust to their daily liquidity
needs. It is available only for a day.
Term Repo Rate
A term repo is a repo valid for more than a day. The word term indicates a longer duration. In
India, the term repo has different durations such as 7 days, 14 days and 28 days.
Term repo tends to pay a significantly higher rate of interest as their maturity is greater than a
day. Moreover, the collateral risk is higher for term repo than overnight repo as the value of
the assets used as collateral has a higher chance of declining in value over a more extended
period. The financial institution which purchases the security is not allowed to sell them to
another party unless the seller defaults on its obligation to repurchase the security. The security
involved acts as collateral for the buyer until the seller can pay the buyer back. Thus, the sale
of a security is treated as a collateralized loan secured by an asset. In India, term repo is
available only when RBI announces it through a term repo auction, and it is generally available
twice in a week. An auction sets the interest rate under the term repo with the cut-off rate above
the repo rate.
Open Repo Rate
Open Repo rate is a repurchase transaction that is agreed upon without fixing the maturity date.
The distinguishing element of the term repo is that it can be terminated on any business day by
either party in the future, provided they give notice within an agreed period of time.
Until an open repo is terminated, it automatically runs from one day to the next, offering the
convenience of not having to negotiate and settle daily roll-overs. Interest accrues daily but is
not compounded (i.e. interest is not earned each day on interest accrued over previous days)

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 Effect on GDP

Repo Rate Vs GDP

10 4000000
8 3000000
6
2000000
4
2 1000000
0 0
2015 Q1
2015 Q2
2015 Q3
2015 Q4
2016 Q1
2016 Q2
2016 Q3
2016 Q4
2017 Q1
2017 Q2
2017 Q3
2017 Q4
2018 Q1
2018 Q2
2018 Q3
2018 Q4
2019 Q1
2019 Q2
2019 Q3
2019 Q4
2020 Q1
2020 Q2
2020 Q3
Repo rate GDP in crores

Increased repo rate – Banks find it more difficult to avail loans from the RBI when the
repo rate increases. As a result, banks tend to increase their lending rates which makes it
more difficult for industries and common man to borrow money from banks. Money supply
decreases and consumption, expansion and production also reduces. Therefore, increased
repo rate hinders GDP growth.

Reduced repo rate – With a decrease in repo rates, the short term loans for banks become
comparatively cheaper. This reduces the banks’ lending rates. Consumption increases as
people are left with more money and this has a positive effect on GDP growth. Moreover,
now the industries are attracted to take loans and make investments which results into
increase in aggregate demand and hence the GDP increases.

Why the continuous decrease in repo rate in 2019 has not yet resulted in the increased
GDP growth?

• Staggered and incomplete monetary transmission: Loans are not getting any cheaper,
because banks are shying away from transferring the entire repo rate cut to customers. A
reduction is repo rates would mean banks will need to pay less for borrowings and are
ideally supposed to pass on this benefit to customers. In either scenario, this has
weakened the market and showed that growth can wait from a policy point of view.

• Economic Slowdown: The recent economic slowdown has been exasperated by a

decline in consumption, it has not been driven by a surplus on the supply side.

• Agrarian distress and dismal income growth: The present agrarian distress and
disappointing income growth so far, coupled with dismal income growth expectations in
urban areas, have weakened consumption demand

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 Effect on Inflation

Repo Rate Vs Inflation

10.00% 10
8.00% 8
6.00% 6
4.00% 4
2.00% 2
0.00% 0
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
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Inflation Repo rate

Inflation and interest rates are often linked and frequently referenced in macroeconomics.
Inflation refers to the rate at which prices for goods and services rise. In India, the interest rate,
or the amount charged by a lender to a borrower, is based on the Repo Rate that is determined
by the Reserve Bank of India.

By setting the target for the Repo Rate, the RBI has at its disposal a powerful tool that it uses
to influence the rate of inflation. This tool enables the RBI to expand or contract the money
supply as needed to achieve target employment rates, stable prices, and stable economic
growth.

Current Scenario in India

A comprehensive measure used for estimation of price changes in a basket of goods and
services representative of consumption expenditure in an economy is called consumer price
index.

Over the last six months i.e., March-August 2019 consumer price index (CPI) inflation trailed
below the target of 4.0 per cent averaging 3.1 per cent over this period. Its key driver was food
prices which emerged out of deflation in March 2019 and gradually firmed over the ensuing
months in the usual summer season upturn. In contrast, prices of fuel and light items remained
soft and slumped into deflation during July-August 2019. Excluding food and fuel, inflation
ebbed by around 100 basis points between March- June 2019 and reached a 23-month low in
June 2019, before registering some uptick during July-August.

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Key Takeaways

• There is an inverse correlation between interest rates and the rate of inflation.
• In India, the Apex Bank is responsible for implementing the country's monetary policy.
• In general, when interest rates are low, the economy grows and inflation increases.
• Conversely, when interest rates are high, the economy slows and inflation decreases.
• Central banks manipulate short-term interest rates to affect the rate of inflation in the
economy.

Effect on Exchange Rate

Repo Rate VS Exchange Rate

9 80
8 70
7 60
6 50
5
40
4
3 30
2 20
1 10
0 0
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
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Repo rate Exchange rate($)

When repo rate increases, the money supply in the economy falls and thus the demand for
domestic currency rises. This leads to a decrease in exchange rate. As a result, import increases
and export decreases.

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Effect on borrowers EMIs?

On October 1, 2019, RBI has mandated for all the banks to link any personal, housing or auto
loans to one of the 4 external rates specified by the Reserve Bank of India (RBI).
Banks can benchmark the interest charged on the loans that they offer to any one of the
following:
• RBI's repo rate,
• Government of India three-months Treasury Bill yield published by the Financial
Benchmarks India Private Ltd. (FBIL),
• Government of India six-months Treasury Bill yield published by the FBIL and
• Any other benchmark market interest rate published by the FBIL
The interest rate on home loans, vehicle loans offered by several banks is linked to RBI's repo
rate. How do the changes in repo rate effects borrower's EMIs? RBI's circular states that the
interest rate linked to an external benchmark has to be reset at least once in three months. Let
say RBI cuts its repo rate on October 1st, interest rates don’t necessarily have to be reset only
on January 1st. It can happen anytime within the 3 months. It is, however, mandatory to reset
interest rates at least once every 3 months, effective from 1st October 2019.The aim of fixing
the reset period is to make sure that policy transmission happens for the majority of customers.

Example:
Rahul Dewan takes a loan on September 16 with a reset period of 3 months. Let say in
November RBI cuts the repo rate by 25 bps. In this scenario, as per the new rule, the borrower
will not get the immediate benefit of the rate cut as the interest rate on his loan will only get
revised in December on the reset date. However, if the apex bank cuts the repo rate again in
December, the borrower could benefit from both of these rate cuts.

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 Recommendation

• The way out of this slowdown could be a revival in consumer sentiment, especially in
terms of income expectation. This should be done by addressing rural demand.
• “The government should loosen its purse strings and do a massive fiscal front-loading
in the economy,” says Gita Gopinath, chief economist, IMF.
• An increase in infrastructure spending could create jobs in the rural sector, leading to
a generation of demand.

Bibliography

1. https://dbie.rbi.org.in/DBIE/dbie.rbi?site=home – For GDP, inflation, repo rate,

exchange rate, etc. data collection

2. https://www.investopedia.com/terms/r/repurchaseagreement.asp

3. https://economictimes.indiatimes.com/definition/Repo-rate

4. https://economictimes.indiatimes.com/news/economy/policy/india-should-focus-
on-structural-reforms-clean-up-of-banks-and-labour-
reforms/articleshow/72755716.cms

5. https://m.rbi.org.in/Scripts/HalfYearlyPublications.aspx?head=Monetary%20Policy%
20Report

6. https://www.investopedia.com/ask/answers/12/inflation-interest-rate-
relationship.asp

7. https://www.business-standard.com/article/economy-policy/explained-why-rbi-s-
repo-rate-cuts-are-not-enough-to-bolster-gdp-growth-119120400177_1.html

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