Trend of Repo-rate and Inflation

Repo-Rate:

• ‘Repo Rate’ is the rate at which RBI (Reserve Bank of India) lends money to commercial banks. RBI is the Central Bank of India.

• Repo Rate = Repurchase Agreement

• Banks borrow money from RBI at repo rate in order to meet short term requirements.

Inflation:

• Inflation is increase in price of goods and services. The purchasing power of rupee decreases as a result of inflation. Inflation can be either supply driven or demand-driven. If the inflation is demand-driven (increase in demand), it is good for the economy as a whole whereas if the inflation is supply-driven (decrease in supply), it is undesired for the economy.

• CPI (Consumer Price Index) is a benchmark to calculate inflation India.

Relationship between Repo-rate and Inflation:

• Inflation indicates that there is more money in the economy and deflation indicates that there is shortage of money in the economy. RBI manipulates repo rate in order to control such situations and maintain stability in the economy.

• Let us understand effects of the inflation. If Demand increases/ Supply decreases => there is more money with people => more people are willing to buy goods and services => price of goods and services increases => INFLATION

• RBI increases repo rate to reduce inflation pressure on the economy.

• If repo rate is increased => high interest rates => less borrowings by consumers => inflation pressure reduced.

• RBI uses repo rate as a tool to control inflation. There is an instrumental relationship between repo rate and inflation.

• There is a direct relationship between repo rate and inflation. 

      RBI controls the money supply and primarily works on the               following equation:

          Gm = Gp + K*Gy

  

          Where,

          Gm = growth in money supply

          Gp = Growth in price of goods and services (Inflation)

          Gy = Growth in income (GDP)

          K = constant

Thus, the primary function of RBI is to ensure the growth in income with price control.

Fig 1 shows the trend in Inflation in India from 2001 to 2015. Fig 2 shows trend in repo rate in India from 2001 to 2015. Both charts clearly indicate that Repo-rate and Inflation have direct relationship.

                                   

Fig 1

                                               Fig 2

Conclusion:

The objective of RBI is to maintain constant money supply with price control and sustainable growth in control. Price (Inflation) is monitored and controlled by RBI by manipulating the repo-rate. As repo-rate has a direct relationship with inflation, Price increment forces RBI to increase the repo-rate and vice-versa.

References:

1. http://www.global-rates.com
2. http://www.tradingeconomics.com/
3. http://www.inflation.eu/inflation-rates/india

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About the Author

This report has been prepared by Paavan Desai and published by Jayant Gupta, pursuing MBA from Institute of Management, Nirma University located in Ahmedabad, India.

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