Explain the role of Repo rate and Reverse Repo rate in correcting deflationary gap in an economy.

Question

Accepted Answer

Role of Repo Rate and Reverse Repo Rate in correcting deflationary gap:

Deflationary Gap: When aggregate demand is less than aggregate supply at full employment level.

Repo Rate:
- RBI decreases Repo Rate
- Cost of borrowing for banks decreases
- Banks reduce lending rates
- Borrowing becomes cheaper
- Consumption and investment increase
- Aggregate demand increases
- Deflationary gap is corrected

Reverse Repo Rate:
- RBI decreases Reverse Repo Rate
- Banks earn less by depositing with RBI
- Banks prefer to lend more to public
- Credit availability increases
- Money supply increases
- Aggregate demand increases
- Deflationary gap is corrected

Both rates work together to stimulate economic activity and correct deflationary gap.