‘‘To boost the falling demand in the economy, the Reserve Bank of India recently reduced Repo rate.’’ Elaborat

Question 27 of 67

Q. ‘‘To boost the falling demand in the economy, the Reserve Bank of India recently reduced Repo rate.’’ Elaborate the rationale behind the steps taken by the Central Bank.

Punjab PsebCBSE Class XII Board 2020Subjective· 4mImportance★★★★★

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Concept understanding — Money Supply Measures

Money Supply Measures: From Pocket Money to the Whole Economy

Think about the money you actually use. You have some cash in your wallet, maybe a few coins for the bus. You might have a ₹500 note tucked away. But you also have money in your bank account — the kind you can swipe on a card or transfer through UPI. That's money too, even though you never see it as paper.

Now imagine the entire country. Every person, every shop, every company, every government office — all the money they hold in cash and in their bank accounts. That total is what economists call the money supply. It's not just the currency printed by the RBI. It's the total stock of money available in the economy at a given point in time.

Why does this matter?

The money supply affects everything: how much prices rise (inflation), how easily you can get a loan, how much the government can spend, and even the value of the rupee. The RBI controls the money supply to keep the economy stable. But to control it, you first need to measure it — and that's where the confusion begins.

The problem: Not all money is the same

A ₹100 note in your pocket is clearly money. But what about the ₹10,000 sitting in your savings account? You can't hand that to a shopkeeper as a physical note, but you can withdraw it anytime or pay via UPI. So it's almost as good as cash.

What about a fixed deposit of ₹1 lakh? You can't use it to buy lunch today — you'd have to break the deposit, which takes time and may cost you interest. So it's less "money-like" than cash, but it's still a form of stored purchasing power.

The RBI solves this by defining four measures of money supply, each broader than the last. They are called M1, M2, M3, and M4. Think of them as concentric circles: M1 is the narrowest (most liquid), M4 is the broadest (includes less liquid forms).

The four measures (as per NCERT Class 12)

M1 = CU + DD

Where:

CU = Currency held by the public (notes + coins, excluding cash held by banks)
DD = Net demand deposits of banks (the money in your current and savings accounts that you can withdraw on demand)
Net time deposits = Fixed deposits, recurring deposits, etc. — money you cannot withdraw immediately without penalty

What each measure captures

M1 is the money you can spend right now — cash in hand plus money in your bank account that you can withdraw or transfer instantly. This is called narrow money. It's the most liquid.

M2 adds post office savings deposits. In India, post offices also accept savings deposits, and these are quite liquid (you can withdraw them on demand). But they're not part of the commercial banking system, so they're added separately.

M3 is the most commonly used measure for policy. It adds all time deposits (fixed deposits, etc.) to M1. This is called broad money. Why include fixed deposits? Because they can be converted into cash quickly (though with some loss of interest). They represent purchasing power that is just a step away from being spendable.

M4 adds post office deposits (excluding National Savings Certificates, which are less liquid) to M3. This is the broadest measure.

Which one do economists actually use?

In India, the RBI primarily tracks M3 for monetary policy. You'll see it in news headlines: "Money supply (M3) grew by 10% this year." M1 is also tracked for short-term liquidity analysis.

Note

The RBI publishes these numbers every week. As of recent data (you don't need to memorise exact figures), M3 is roughly ₹200+ lakh crore — a number so large it's hard to imagine. But the growth rate is what matters for policy. …

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A reduction in the Repo rate lowers the cost for commercial banks to borrow from the RBI, which in turn allows them to reduce their lending rates to businesses and individuals, thereby encouraging more borrowing and spending, ultimately boosting aggregate demand in the economy.

The Reserve Bank of India (RBI) uses various tools to manage the money supply and credit conditions in the economy, a process known as monetary policy. One of its most potent tools is the Repo rate. Understanding why a reduction in this rate is expected to boost demand requires tracing the ripple effect it has through the banking system and into the broader economy.

The core idea is that by making it cheaper for banks to borrow money, the RBI encourages them to lend more cheaply to the public. This cheaper credit then incentivizes businesses to invest and individuals to consume, directly stimulating economic activity and demand.

Here is the rationale behind the RBI's action:

Understanding the Repo Rate: The Repo rate (Repurchase Rate) is the interest rate at which commercial banks borrow money from the RBI by selling government securities with an agreement to repurchase them at a later date. It is essentially the cost of short-term borrowing for commercial banks from the central bank.
Reduced Borrowing Costs for Commercial Banks: When the RBI reduces the Repo rate, it directly lowers the cost for commercial banks to borrow funds from the central bank. This makes it cheaper for banks to acquire liquidity when they need it.
Lower Lending Rates for Businesses and Individuals: With reduced borrowing costs, commercial banks are in a position to lower the interest rates they charge on loans to their customers – both businesses and individuals. This is because their own cost of funds has decreased, allowing them to maintain their profit margins even with lower lending rates.

Tip

The Repo rate acts as a benchmark. Changes in the Repo rate often lead to corresponding changes in other interest rates in the economy, such as the Marginal Cost of Funds Based Lending Rate (MCLR) or External Benchmark Based Lending Rate (EBLR) that banks use to price their loans.
Increased Borrowing and Investment by Businesses:
- For businesses, lower interest rates mean that the cost of financing new projects, expanding operations, or purchasing new machinery becomes cheaper.
- This encourages them to take on more loans for investment purposes, as the expected returns on their projects are more likely to exceed the reduced cost of borrowing. Increased investment directly contributes to higher aggregate demand.
Increased Borrowing and Consumption by Individuals:
- For individuals, lower interest rates translate into cheaper home loans, car loans, personal loans, and other forms of credit.
- This makes it more attractive for them to borrow money to purchase goods and services, such as houses, vehicles, consumer durables, or even to fund education. Increased consumption spending is a major component of aggregate demand. …

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Q.‘‘To boost the falling demand in the economy, the Reserve Bank of India recently reduced Repo rate.’’ Elaborate the rationale behind the steps taken by the Central Bank.

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