Monetary Policy and Demand in economy

Subject: Economy

Context:

In the last monetary policy committee meeting, RBI governor expressed the need for boosting investment and consumption through easing finance conditions.

Concept:

After cutting interest rates by 75 basis points (bps) in March, the central bank further brought down the repo rate by 40 bps to 4% in May in a bid to revive demand amid a slowing economy.

Monetary Policy and Aggregate Demand

• Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand.
• Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand.
• Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital.
• In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars.
• Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.
• If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP.

R- interest rate, I-investment, C-consumption, P-price