The Reserve Bank of India (RBI) cut the repo rate by 25 basis points to 6 per cent in the first

bi-monthly
monetary policy meet of the financial year (FY) 2019-20. It was the first back-to-back rate cut by the
central bank since the Monetary Policy Committee (MPC) was formed in late 2016.

(i) Analyze the reasons behind this decision of change in calibrated tightening of the policy

Monetary policy relates to the control of the supply of money available in the economy. Monetary Policy
is implemented in India by RBI (Central Bank). There are two main objectives of monetary policy

1. Control inflation
2. Promote economic growth

Economic growth is affected by interest rate. Monetary Policy impacts firms through its influence on
interest rate. Interest rate is the price of money. Hence it depends on demand and supply of money.

Demand of money:
 Consumer
 Business
 Government (due to fiscal deficit)

Supply of money:
 Savers
 Foreign investors
 RBI (by printing more notes). RBI controls supply of money

Money is supplied by savers, the central bank of the country, when it prints more notes and foreign
investors.

When foreign investors invest money in the domestic country, they bring in foreign currency and
exchange it for domestic currency to invest it in some saving instruments like shares and bonds etc. They
thus make money available for supply
Rate of interest is determined by interaction of demand and supply of money. When rate of interest rises,
demand of money will fall and vise versa, hence demand curve of money is downward sloping.

RBI does not allow market to determine supply of money. It takes decision on requires money supply in
the market depending on prevailing macroeconomic situation and regulates the supply of money in
different form. The rate of interest is determined at the point where the demand for money is equal to the
supply of money.

Repo rate: The rate at which banks borrows money from RBI. RBI Monetary Policy Committee (MPC)
reduces repo rate by 25 basis points to 6% on 2nd /3rd April 2019 meeting.

One of the objective of Monetary policy is to promote economic growth. Change in economy have impact
on interest rate.

Following could be the reasons for the change in calibrated tightening policy in April 2019.

Economic Growth

GDP is responsible for economic activity. Economic activity is the result of aggregate demand and
aggregate supply of good and services curve. GDP is an important indicator of an economy’s progress
and growth.

Fundamental national income accounting identity is:

GDP= C+I+G+(X-M)

C= Consumption, This includes household spending on anything from food to education to leisure
activities, excluding household expenditure on new houses as that is considered as investment.

I= Investment in business, construction, land, plant, machinery, etc Investment is important in GDP as it
increases an economy’s ability to produce output in the future.

G=Government expenditure,

X=Exports,

M=Imports

Aggregate Demand is inversely proportional to general price level. When there is a fall in the general
price level, there is a rise in the aggregate demand and when there is a rise in the general price level, there
is a fall in the aggregate demand. There is an effect arising out of a fall in the general price level on
Interest Rate

There is rise in the demand for investment goods, because a fall in prices leads to a fall in interest
rate. When Aggregate demand(AD) = Aggregate supply (AS) is called GDP. Hence every economy is
trying to shift AD curve to right.

Central Statistics Office (CSO) in February 2019 revised India’s real gross domestic product (GDP)
growth downwards to 7.0% from 7.2%. Domestic economic activity decelerated for the third consecutive
quarter in Q3:2018-19 due to a slowdown in consumption, both public and private. (source RBI website)

As can be seen that domestic economic activity decelerated. Hence in order to promote economic growth,
RBI reduced interest rate by 25 bsp. By reducing interest rate, price of money reduces. It will generate
demand for investment goods because of fall in interest rate. Hence AD curve will tend to shift to right
helping GDP growth to improve.

Inflation

Another factors which determines interest rate is inflation. Inflation refers to the rate of increase in price.
If we consider that the demand and supply of money measured on the X axis is the real demand and real
supply of money, then inflation plays a role in interest rates. Real supply of money is the supply of money
adjusted for inflation.

The price level or level of inflation is determined at that point where AD intersects AS.

Inflation is a function of aggregate demand and aggregate supply in the economy. When aggregate
demand is more than aggregate supply, there is inflation. This could be because demand has increased or
because supply has reduced.

As a part of monetary policy, when there is inflation, the central bank raises the rate of interest so that it
becomes costlier for banks to borrow and in turn banks raise the rate of interest they charge on the
loans they give to their customers. This in turn reduces the aggregate demand in the economy and thus
reduces inflation.
April’s monetary policy decision could also be influenced by inflation considerations. In February,
consumer price inflation accelerated to 2.6% from 2.0% in January, however it remained close to the
lower bound of the MPC’s target range of 2.0% to 6.0%. When price level increases, demand of money
increases for consumption and results in higher interest rate. However currently in economy CPI is lower
than RBI target range. (source RBI website)

Slower than expected GDP growth as well as lower inflation rate has led to the decision of change in
calibrated tightening of the policy. Hence RBI decided to reduce Repo rate by 25 bsp to 6%.