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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

The Reserve Bank of India raises its policy repo rate and, through open market operations, reduces liquidity in the banking system. Which combination of consequences best describes the expected transmission to firms in the short run?

Tighter policy raises banks' funding costs and lending rates, so firms face higher borrowing costs, cut investment, and aggregate demand falls. Bond yields rise rather than fall, and higher rates tend to attract capital and strengthen the currency rather than weaken it.

  1. ABank lending rates tend to rise, borrowing costs for firms increase, and investment demand tends to fall, reducing aggregate demandCorrect
  2. BBank lending rates fall because deposits become more attractive, so investment rises
  3. CBank lending rates are unaffected because they are set by the market alone, so investment is unchanged
  4. DBond prices rise because yields fall, encouraging firms to borrow more
  5. The rupee tends to depreciate because higher rates deter foreign capital inflows, so exports rise strongly and aggregate demand rises

Explanation

A higher repo rate and tighter liquidity raise banks' funding costs and lending rates, increasing the cost of capital for firms and reducing investment and aggregate demand. Higher rates usually attract capital inflows and tend to appreciate, not depreciate, the currency. Bond yields rise and prices fall, so the bond option is wrong.

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