Model Answer

The repo rate is the rate at which the RBI lends short-term funds to banks. A repo rate hike makes borrowing costlier and helps reduce excess demand and inflationary pressures in the economy.

How Repo Rate Hike Controls Inflation

1. Costlier credit reduces borrowing by households and businesses. e.g: Home, vehicle and personal loan rates may rise.
2. Lower consumption reduces aggregate demand and demand-pull inflation.
3. Reduced investment demand moderates excessive economic activity.
4. Credit growth slows as banks transmit higher policy rates to borrowers.
5. Inflation expectations are anchored by signalling RBI’s commitment to price stability.
6. Rupee support can reduce imported inflation by limiting currency depreciation.

Impact on the Indian Economy

1. Higher EMIs reduce disposable income of borrowers.
2. Business costs rise, particularly for MSMEs dependent on bank credit.
3. Investment may slow as financing new projects becomes expensive.
4. Rate-sensitive sectors may experience weaker demand. e.g: Housing and automobiles.
5. Savers benefit from potentially higher deposit interest rates.
6. Growth-inflation trade-off emerges as lower demand can moderate economic growth.

Way Forward

1. Calibrate rate hikes according to evolving inflation and growth conditions.
2. Complement monetary policy with fiscal and supply-side measures. e.g: Managing food supply and diversifying crude-oil imports.
3. Maintain clear RBI communication to anchor inflation expectations.

Repo rate hikes can effectively moderate demand-side inflation, but supply shocks require complementary fiscal and supply-side measures. A balanced approach is essential for maintaining price stability without unnecessarily weakening growth.