Why RBI is decreasing Interest Rates?

During the times of slow economic growth, Central banks like FED(USA), RBI(INDIA) etc., decreases the interest rates to boost the economy. Currently, the economy is slowed down not only in emerging markets like India but also all over the world. To give a boost to the Indian economy, RBI is continuously decreasing the interest rates. But how does a decrease in the interest rate would improve the economy? To know the answer read till the end of this article.

Before digging further I take an opportunity to explain a few terms in an easy manner which helps you to understand the concept in a better way.

  1. Inflation – Have you ever observed, the things which your father bought for Rs.100/-  during his time now you might be buying them for Rs.500/-. So what exactly happened here is that the price of the products increased but the quantity remained the same. This is called Inflation. Due to inflation costs of goods and services increased but the purchasing power of money got decreased. Inflation depreciates the value of money.
  2. Deflation – This is quite opposite of Inflation. During the period of deflation, the cost of goods and services decreases and the purchasing power of money decreases. This happens during the time of recession. So this situation is very rare.
  3. Repo Rate – Repo Rate is the interest rate at which Central Bank (RBI, FED etc.,) lends money to banks.
  4. Reverse Repo Rate – This is opposite of Repo Rate. Reverse repo rate is the interest rate at which RBI takes money from Banks. Usually, Central Banks do this when there is more money with the public to control the deflation.

Now let us find the answer to our main question i.e., How decreasing interest rates will boost the economy? 

Affect of Repo rate cut

When the central bank decreases the repo rate, the banks get money for less interest rate. Since banks get money for less interest rate, they cut the rate on loans. This entire situation provides an opportunity for the industries to expand. Companies looking for expansion take loans because they are getting money for less rate.

In this process, unemployment decreases. People earn more and spend more. This makes businesses to improve, indirectly the flow of money in the market increases. Thus cutting the repo rate boosts the economy.

You can know what happens when Central Bank raise interest rates and relation between the Interest Rates and Recession by reading this article – RELATION BETWEEN RECESSION AND INTEREST RATES

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