Question 4 [20 Marks] 4.1 Discuss the monetary transmission mechanism when the Reserve Bank DECREASES the Repurchase rate.
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Repurchase rate is the monetary policy rate of interest at which central bank lends money to the commercial banks. Central bank would decrease repurchase rate when it wishes to implement expansionary monetary policy.
Decline in repurchase rate means decline in the rate of interest at which central bank lends money to the commercial banks. This motivates commercial banks to borrow more funds from central bank. Cost of funds for commercial bank decreases because of decline in repurchase rate.
As cost of funds for commercial bank decreases, commercial banks pass on the benefits to borrowers i.e. benefits are transferred on to firms and households in the form of low interest rates that charged on loans firms and households borrow from commercial banks.
As the interest rate that firms and households will have to pay decreases, firms and households are motivated to borrow more and spend more.
Firms borrow more, to be able to purchase capital goods, thereby resulting in an increase in investment spending in the economy.
Households borrow more, to be able to purchase consumer goods and services, thereby resulting in an increase in consumption spending in the economy.
Both investment spending and consumption spending are part of aggregate demand.
An increase in investment spending and consumption spending, causes aggregate demand to increase.
An increase in aggregate demand, causes price level in the economy to increase.
An increase in price level, means there is an increase in prices of goods and services.
As prices of goods and services rise, producer’s profit margins increase and thus producers are motivated to produce more.
This results in an increase in production of goods and services, which causes real GDP in the economy to increase.
As production of goods and services increases, it results in an increase in demand for labor, thereby causing unemployment in the economy to fall.
In such manner, lowering of repurchase rate can stimulate the economy, thereby leading to an increase in real GDP, decline in unemployment rate, and an increased economic activity.