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Home Economy

Monetary Transmission

January 30, 2021
in Economy
Reading Time: 3min read
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Monetary Transmission
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In News: Banks with higher capital ratios transmit monetary policy actions more smoothly than banks with lower capital base according to recent study by RBI .

Concept 

  • The RBI study attempts to understand the link between bank capital and monetary transmission by looking at the relationship between bank capital and loan growth/cost of funds.
  • It states that for each one percentage point increase in CRAR, there is a 7.8 percentage points rise in loan growth rate. On the contrary, one percentage point increase in GNPA ratio reduces the loan growth rate by 0.9 percentage points.
  • In effect, while rise in capital ratio helps in better monetary policy transmission, a significant amount of stressed assets could limit credit supply.

What is monetary policy transmission ?

  • Repo rate is the interest rate that the RBI charges the banks when it lends them money.
  • The banks’ lending rate is the interest rates that banks charge from customers when they take a loan.
  • By cutting the repo rate, the RBI has been sending a signal to the rest of the banking system that the lending rates in the system should come down.
  • This process of repo rate cuts leading to interest rate cuts across the banking system is called “monetary policy transmission”

What was RBI’s response?

  • In response to the sluggish transmission, the RBI decided to cut the repo rate by another 25 basis points in October 2019.
  • It urged banks to link their lending rates to the repo rate.
  • Yet, for the most part, the banking system has ignored the signalling.
  • Only some banks have reduced lending rates on new loans by 10 basis points.
  • Indeed, even though it is counter-intuitive, interest rates on existing loans (not new loans) have actually.

How does lowering interest rates help?

  • A lower interest rate regime is expected to help in resolving both of these.
  • Consumption 
    • The prevalent argument is that if banks reduce their lending rates, they would also have to reduce their deposit rates.
    • Reducing deposit rates will, in turn, incentivise people to save less and spend more i.e. increased consumption.
    • [Deposit rate is the interest rate banks pay when consumers park their money in a savings bank deposit or a fixed deposit.]
  • Investment 
    • The low investment by businesses is partly because they have unsold inventories because people are not buying as much.
    • But, part of the reason is also that the interest rate charged on loans is quite high.
    • If interest rates are lowered, more businesses are likely to be enthused to borrow new loans for investment.
    • This is particularly fitting as the government has recently cut corporate tax rates in the hope to boost investment and corporate sector’s profitability.
  • So, given that overall retail inflation too has been well within the comfort zone of 4%, the RBI’s decision to cut repo rates was a justified move.

 

Source: The Hindu
Tags: PIBPrelims

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