Flash Card

LAKSHYA-75 [Day-42] Static Flash Cards for IAS Prelims 2020

Repo Rate; Reverse Repo Rate; GDP Deflator; Difference between GDP Deflator and other Price Indices; Nominal GDP; Real GDP; Gross Domestic Product (GDP); Small Finance Banks (SFBs); Silk Road Economic Belt (SREB) initiative; TReDS; External Commercial Borrowings (ECB); Market Stabilisation Scheme (MSS); National Skills Qualifications Framework (NSQF); Flexible inflation targeting (FIT);
By IASToppers
April 20, 2020

Flexible inflation targeting (FIT) has been put in place with CPI inflation as the nominal anchor on the recommendation of which committee?

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  • Following the Urjit Patel Committee recommendations, the RBI Act has been amended and flexible inflation targeting (FIT) has been put in place with CPI inflation as the nominal anchor.

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Prior to the introduction of the all-India Consumer Price Index, popularly known as CPI combined (rural plus urban), the Wholesale Price Index (WPI) was the most useful price index in India.

  • It measured the weekly rhythm of price movement in the country.
  • The Reserve Bank of India (RBI) primarily used WPI inflation for the formulation of monetary policy under monetary targeting framework as well as under multiple indicator approach (MIA)— although inflation measured by other indices was also monitored/ analyzed.
  • Moreover, the Central Statistics Office (CSO) has been predominantly using WPI to deflate GDP at current prices to arrive at GDP at constant prices.
  • Where only volume data are available, the CSO uses WPI to convert volume to value to arrive at GDP at current prices.

Effects of low WPI:

  • WPI inflation does not receive as much attention as earlier for several reasons. Following the Urjit Patel Committee recommendations, the RBI Act has been amended and flexible inflation targeting (FIT) has been put in place with CPI inflation as the nominal anchor.
  • Under the FIT, as the RBI has been mandated to achieve price stability measured in terms of CPI inflation, the use of WPI inflation has been completely done away with.
  • All projections relating to inflation are currently done in terms of CPI.
  • As of now, WPI is predominantly used for converting GDP/GVA at current prices to the same at constant prices.
  • Several items of services sector GDP that are not included in the WPI basket are deflated by WPI to compute real GDP of this sector.
  • In fact, the GDP deflator, which is defined as a ratio of GDP at current prices to GDP at constant prices multiplied by 100, closely tracks WPI inflation.
  • The GDP deflator, which is often argued as the true indicator of inflation, has been at the focal point of discussion while analyzing the real GDP growth in India during the recent period.
  • The sharp decline in the GDP deflator and the dramatic decline in WPI inflation coincided.
  • This contributed significantly to real GDP growth in India notwithstanding modest rise in production during recent years.
  • In order to ensure accuracy, it is high time to discard the single deflation method to estimate GDP/GVA by using WPI as a deflator.
  • What is therefore needed is to compute both input and output price indices for each sector and adopt double deflation method at the earliest as suggested by the System of National Accounts (SNA) 2008 – the standard compilation manual of the IMF for the estimation of GDP.
  • Separate services sector input/output price indices are required to deflate services sector GDP for which WPI is anyway not appropriate.
  • The attention of authorities concerned is called for, to resolve issues relating to the GDP deflator in India, as WPI has lost some of its usefulness.

National Skills Qualifications Framework (NSQF) supersedes which other frameworks released previously?

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  • All other frameworks, including the NVEQF (National Vocational Educational Qualification Framework) released by the Ministry of HRD, stand super ceded by the NSQF.

Enrich Your Learning:

National Skills Qualifications Framework (NSQF)

National Skills Qualifications Framework (NSQF), is a quality assurance framework which organizes qualifications according to a series of levels of knowledge, skills and aptitude.

  • These levels, graded from one to ten, are defined in terms of learning outcomes which the learner must possess regardless of whether they are obtained through formal, non-formal or informal learning.
  • Under NSQF, the learner can acquire the certification for competency needed at any level through formal, non-formal or informal learning.
  • The NSQF is anchored at the National Skill Development Agency (NSDA) and is being implemented through the National Skills Qualifications Committee (NSQC) which comprises of all key stakeholders.

Specific outcomes expected from implementation of NSQF are:

  • Mobility between vocational and general education by alignment of degrees with NSQF.
  • Recognition of Prior Learning (RPL), allowing transition from non-formal to organized job market.
  • Standardised, consistent, nationally acceptable outcomes of training across the country through a national quality assurance framework.
  • Global mobility of skilled workforce from India, through international equivalence of NSQF.
  • Mapping of progression pathways within sectors and cross-sectorally.
  • Approval of NOS/QPs as national standards for skill training.

Key Facts:

  • The framework is anchored and operationalized by the National Skill Development Agency (NSDA), an autonomous body attached to the Ministry of Finance, mandated to coordinate and harmonize skill development efforts of the Government of India and the private sector.
  • All other frameworks, including the NVEQF (National Vocational Educational Qualification Framework) released by the Ministry of HRD, stand super ceded by the NSQF.

When is Market Stabilisation Scheme (MSS) to be used?

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  • Market Stabilization Scheme(MSS) is used when there is high liquidity in the system.

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About Market Stabilisation Scheme (MSS)?

Market Stabilisation Scheme or MSS is a tool used by the Reserve Bank of India to suck out excess liquidity from the market through issue of securities like Treasury Bills, Dated Securities etc. on behalf of the government.

  • The money raised under MSS is kept in a separate account called MSS Account and not parked in the government account or utilized to fund its expenditures.
  • The Reserve Bank under Governor YV Reddy initiated the MSS scheme in 2004, to control the surge of US dollars in the Indian market, RBI started buying US dollars while pumping in rupee.
  • This eventually led to over-supply of the domestic currency raising inflationary expectations.
  • MSS was introduced to mop up this excess liquidity.   
  • The bills and securities issued for the purpose of MSS is matched by an equivalent cash balance held by the Government with the Reserve Bank.
  • Thus, there is a marginal impact on revenue and fiscal deficits of the Government to the extent of interest payment on bills/securities outstanding under the MSS.  
  • Further, the cost is shown separately in the Budget.

Intention of introducing the MSS:

  • It is to differentiate the liquidity absorption of a more enduring nature by way of sterilization from the day-to-day normal liquidity management operations.
  • The total absorption of liquidity from the system by the Reserve Bank will continue to be in line with the monetary policy stance from time to time and accordingly, the liquidity absorption will get apportioned among the instruments of LAF, MSS and normal open market operations (OMOs).

Key Facts:

  • The issued securities under the MSS are government bonds and they are called as Market Stabilisation Bonds (MSBs).
  • These securities are owned by the government though they are issued by the RBI.
  • The securities or bonds/t-bills issued under MSS are purchased by financial institutions.
  • After demonetization Reserve Bank of India has raised the ceiling for market stabilization scheme or MSS 20 times to Rs 6 lakh crore to suck excess cash out of the banking system and help banks earn some return from the deluge of deposits they have garnered after the government’s demonetization move.

About Carrying cost:

  • The money procured from selling bonds under MSS are kept with the RBI.
  • At the same time, interest payments have to be given to the institutions who buys bond.
  • Here, for the interest payment, the government allocates money from its budget to the RBI.
  • This expenditure to service interest payment for MSBs is called carrying cost.

Difference between CRR and MSS:

  • CRR is a sort of contingency fund and does not earn any interest.
  • MSS bonds, on the other hand, have a fixed tenure and earn returns.

As per the new External Commercial Borrowings norms, what is the ceiling for borrowing remains?

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  • As per the new External Commercial Borrowings norms the ceiling for borrowing remains at $750 million.

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External Commercial Borrowings (ECB)

An external commercial borrowing (ECB) is an instrument used in India to facilitate Indian companies to raise money outside the country in foreign currency.

  • The government of India permits Indian corporates to raise money via ECB for expansion of existing capacity as well as for fresh investments.
  • Foreign currency loans given domestically by Authorized Dealer Category I banks out of the proceeds of FCNR foreign currency nonresident (FCNR – B) loan (B) deposits do not come under the ECB framework.
  • Any contravention of the applicable provisions of ECB guidelines will invite penal action under the (Foreign Exchange Management Act) Act 1999? FEMA.
  • Only those companies in software sector space who are into development of software are eligible to raise ECB. Companies who are into designing and engineering consultancy, servicing of third-party software, providing ancillary IT related services, ITeS, etc., are not considered as software development companies for ECB purposes.
  • If the educational institute/university/ deemed university is registered as a company under the Companies Act 1956/2013, it can raise ECB as a part of infrastructure sub-sector. ECB guidelines as applicable for infrastructure companies would be applicable for such ECBs.
  • ECB can be raised in Indian Rupees (INR) and / or any convertible currency.

Benefits of ECB:

  • The cost of funds is usually cheaper from external sources if borrowed from economies with a lower rate of interest. Indian companies can usually borrow at lower rates from the U.S. and the Eurozone as interest rates are lower there compared to the home country, India.
  • Availability of larger market can help companies satisfy larger requirements from global players in a better manner as compared to what can be achieved domestically.
  • ECB is just a form of a loan and may not be of equity nature or convertible to equity. Hence, it does not dilute stake in the company and can be done without giving away control because debtors do not enjoy voting rights.
  • The borrower can diversify the investor base.
  • It provides access to international markets for the borrowers and gives good exposure to opportunities globally.
  • The economy also enjoys benefits, as the government can direct inflows into the sector, have potential to grow. For example, the government may allow a higher percentage of ECB funding in case of infrastructure and SME sector. This helps in an overall development of the country.
  • Avenues of lower cost funds can improve the profitability of the companies and can aid economic growth.

Disadvantages of ECB:

  • Availability of funds at a cheaper rate may bring in lax attitude on the company’s side resulting in excessive borrowing. This eventually results in higher (than requirement) debt on the balance sheet which may affect many financial ratios adversely.
  • Higher debt on the company’s balance sheet is usually viewed negatively by the rating agencies which may result in a possible downgrade by rating agencies which eventually might increase the cost of debt. This may also tarnish the company’s image in the market and market value of the shares too in eventual times.
  • Since the borrowing is foreign currency denominated, the repayment of the principal and the interest needs to be made in foreign currency and hence exposes the company to exchange rate risk. Companies may have to incur hedging costs or assume exchange rate risk which if goes against may end up negative for the borrowers resulting into heavy losses for them.

New ECB norms as per released in 2019:

  • As part of the Central government’s aim to improve ease of doing business in India, the Reserve Bank of India (RBI) on 16 January 2019 notified a new external commercial borrowings framework (New ECB Framework).
  • The New ECB Framework rationalizes the existing external commercial borrowings framework (Old ECB Framework) by merging the existing Track I (medium-term foreign currency denominated ECB) and Track II (long-term foreign currency denominated ECB) into one track as ‘Foreign Currency Denominated ECB’.
  • Existing Track III (Indian Rupee denominated ECB) and the Indian Rupee denominated bonds (Masala Bonds) route has been merged as ‘Rupee Denominated ECB’.
  • The list of eligible borrowers has been expanded. All entities eligible to receive foreign direct investment can borrow under the ECB framework
  • The RBI kept minimum average maturity period unchanged at three years for all ECBs, irrespective of the amount borrowed. But if a manufacturer raises overseas debt of up to $50 million in a financial year, the minimum average maturity period would be one year.
  • All eligible borrowers can now raise ECBs up to $750 million or equivalent per financial year under the automatic route replacing the existing sector-wise limits.
  • Any entity who is a resident of a country which is financial action task force compliant, will be treated as a recognized lender.
  • The Export-Import Bank and the Small Industries Development Bank of India has been allowed to borrow overseas from recognized lenders.
  • The previous four-tier structure has been replaced by two specific channels: dollar- and rupee-denominated ECBs.
  • The RBI kept minimum average maturity period unchanged at three years for all ECBs, irrespective of the amount borrowed. But if a manufacturer raises overseas debt of up to $50 million in a financial year, the minimum average maturity period would be one year.

What are the various types of ECB?

ECBs can be raised as:

  • Loans, eg., bank loans, loans from equity holder, etc.
  • Capital market instruments, e.g., floating rate notes / fixed rate bonds / securitised instruments, non-convertible, optionally convertible or partially convertible preference shares, FCCB*, FCEB*.
  • Buyers’ credit / suppliers’ credit
  • Financial lease

About FCCB

  • A foreign currency convertible bond (FCCB) is a type of corporate bond issued by an Indian company in an overseas market in a currency different from that of the issuer.
  • Investors have the option of redeeming their investment on maturity or converting the bonds into equity any time during the currency of the bond.
  • The repayment of the principal is in the currency in which the money is raised.

About FCEB

  • In case of a foreign currency exchangeable bond (FCEB), investors have the option of converting the bonds into equity of the offered company.
  • The company issuing FCEB shall be part of the promoter group of the offered company and shall hold the equity shares being offered at the time of issuance of FCEB.

Which public sector enterprise (PSU) became the first PSU to make transaction on RXIL TReDS platform?

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  • State-owned aerospace and defence manufacturer Hindustan Aeronautics (HAL) became the first public sector enterprise (PSU) to make transaction on RXIL TReDS platform.

Enrich Your Learning:

What is TReDS?

TReDS is an online electronic institutional mechanism for facilitating the financing of trade receivables of MSMEs through multiple financiers.

  • The TReDS Platform will enable discounting of invoices/bills of exchange of MSME Sellers against large Corporates including Govt. Departments and PSUs, through an auction mechanism, to ensure prompt realization of trade receivables at competitive market rates.

How does the TReDS system work?

A seller has to upload the invoice on the platform. It then goes to the buyer for acceptance. Once the buyer accepts, the invoice becomes a factoring unit. The factoring unit then goes to auction. The financiers then enter their discounting (finance) rate. The seller or buyer, whoever is bearing the interest (financing) cost, gets to accept the final bid. TReDs then settle the trade by debiting the financier and paying the seller.

The amount gets credited the next working day into the seller’s designated bank account through an electronic payment mode. The second leg of the settlement is when the financier makes the repayment and the amount is repaid to the financier.

Salient Features of TReDS:

  • Unified platform for Sellers, Buyers and Financiers
  • Eliminates Paper
  • Easy Access to Funds
  • Transact Online
  • Competitive Discount Rates
  • Seamless Data Flow
  • Standardised Practices

What are the economic implications of ‘Silk Road Economic Belt (SREB)’ initiative launched by china in 2013?

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Answer & Enrich Your Learning:

Silk Road Economic Belt (SREB) initiative

  • The Silk Road Economic Belt (SREB) initiative, launched by china in 2013 as the Central Asian component of the Eurasian Belt and Road Initiative (BRI), is a trade and infrastructural developmental initiative.
  • It is also called Belt and Road Initiative or One Belt One Road (OBOR).
  • In the ancient days, China, and much of East Asia, was connected to the rest of the world through a route that got its name from China’s biggest export – silk. China is again looking to rebuild a route that will connect Asia, Africa and Europe – a new Silk Road.
  • It consolidates China’s existing economic investments and security-building measures, while launching new projects to link the regions of Central Asia and South Asia more closely with China.

Objectives of the SERB initiative:

  • Finding outlets for excess capacity of its manufacturing and construction industries
  • Increasing economic activity in its relatively underdeveloped western region
  • Creating alternative energy supply routes to the choke points of the Straits of Hormuz and Malacca, through which almost all of China’s maritime oil imports pass
  • Through BRI, China can strengthen its influence over swathes of Asia and Africa, buttressing its ambitions to be a maritime power, and developing financing structures parallel to (and eventually competing with) the Bretton Woods system.
  • It is also the most ambitious global infrastructure project ever envisaged by one country.

Why is SREB important for China?

  • The slowdown in the Chinese economy and excess production of steel, cement and machinery that it cannot consumed has forced the Chinese government to search for new markets for its products.
  • Also, many of China’s production sectors have been facing overcapacity since 2006. The Chinese leadership hopes to solve the problem of overproduction by exploring new markets in neighbouring countries through OBOR. The OBOR initiative will provide more opportunities for the development of China’s less developed border regions.
  • China also intends to explore new investment options that preserve and increase the value of the capital accumulated in the last few decades. OBOR has the potential to grow into a model for an alternative rule-maker of international politics and could serve as a vehicle for creating a new global economic and political order.
  • China has cash and deposits in Renminbi equivalent to USD 21 trillion, or two times its GDP, and expects that the massive overseas investment in the BRI will speed-up the internationalization of the Renminbi.
  • China can also benefit from the New Silk Road project through other means like the easing up of growth of state-owned enterprises as well as an increase in the Chinese people’s income.

Who are interested and who are not?

  • Most of the countries in Asia and all of India’s neighbours, except Bhutan (Bhutan has no diplomatic relations with China), are willing to take part in the project.
  • While some countries like Pakistan and Afghanistan are keen on OBOR, countries like India and Indonesia are wary because of the shift in status quo that this project could cause in sensitive areas like Kashmir and the South China Sea.

Scepticism over SREB:

Contracts and jobs

  • Experts has doubted serious concerns as major part of the contracts and jobs will be given to Chinese firm and people. There has been serious reservation and protest by people in different countries over the implementation of OBOR.

Debt trap:

  • Analysts have pointed how China is pushing countries in its debt trap by giving loans to countries for unviable projects and increasing Beijing’s leverage.
  • Pakistan is already fallen victim of the Chinese debt trap as it has taken USD 50 billion dollar at the market which is going to balloon to USD 90 billion over a 30-year period.
  • Similarly, countries like Sri Lanka and Cambodia has fallen in the Chinese debt trap.

Banks with a small finance bank license can provide basic banking service of acceptance of deposits and lending. Who are the eligible promotors of Small Finance Banks (SFBs)?

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Eligible promoters:

  • Resident individuals/professionals with 10 years of experience in banking and finance
  • Companies and societies owned and controlled by residents will be eligible to set up small finance banks.
  • Existing Non-Banking Finance Companies (NBFCs), Micro Finance Institutions (MFIs), and Local Area Banks (LABs) that are owned and controlled by residents can also opt for conversion into small finance bank

Enrich Your Learning:

Small Finance Banks (SFBs)

  • Small finance banks are a type of niche banks in India. Banks with a small finance bank license can provide basic banking service of acceptance of deposits and lending.
  • The Reserve Bank of India issued guidelines for setting up SFBs in 2014.
  • SFBs clients include small business units, small farmers, Micro, Small and Medium Enterprises (MSMEs) and various other unorganised sectors.
  • The minimum paid-up equity capital for small finance banks shall be Rs. 100 crore.

Objective of establishment of Small Finance Banks (SFBs)

  • Provision of savings vehicles
  • Supply of credit to small business units, small and marginal farmers, micro and small industries and other unorganised sector entities, through high technology-low cost operations.

Activities of SFBs:

  • The small finance bank shall primarily undertake basic banking activities of acceptance of deposits and lending to unserved and underserved sections including small business units, small and marginal farmers, micro and small industries and unorganised sector entities.
  • There will not be any restriction in the area of operations of small finance banks.

Can SFB be converted into universal banks?

  • Yes, but it will require to fulfilling minimum paid-up capital / net worth requirement as applicable to universal banks, its satisfactory track record of performance as a small finance bank and the outcome of the Reserve Bank’s due diligence exercise.


  • Local Area Banks (LABs) was set up in 1996 by the RBI which were low cost structures providing efficient and competitive financial intermediation services in a limited area of operation, i.e., primarily in rural and semi-urban areas.
  • LABs were required to have a minimum capital of Rs. 5 crores and an area of operation comprising three contiguous districts. Presently, four LABs are functioning satisfactorily in India.
  • Taking into account the above and that small finance banks can play an important role in the supply of credit to micro and small enterprises, the RBI decided to licence new “small finance banks” in the private sector.
  • RBI has set guidelines in 2014 for licensing of small finance banks in the private sector. Including the issues relating to their size, capital requirements, etc.

Difference between Small bank, Payments Bank and Commercial bank:

Key facts:

  • There are two types of licenses which are granted by the RBI namely ‘Universal bank licenses’ and ‘Differentiated bank licenses’.
  • Differentiated banks licenses serves a specific demographic region instead of the general mass as a whole. Small Finance Bank (“SFB”) caters different type of customers, mainly the ones who are not being serviced by the big commercial banks.

Which GDP is a measure of the value of the economy’s output that is not adjusted for inflation: (a) Nominal GDP OR (b) Real GDP?

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  • Nominal GDP

Enrich Your Learning:

Nominal GDP

  • The nominal GDP is the value of all the final goods and services that an economy produced during a given year.
  • In other words, it is a macroeconomic measure of the value of the economy’s output that is not adjusted for inflation.
  • It is calculated by using the prices that are current in the year in which the output is produced.
  • The nominal GDP takes into account all of the changes that occurred for all goods and services produced during a given year. If prices change from one period to the next and the output does not change, the nominal GDP would change even though the output remained constant.

Real GDP

  • The real GDP is the total value of all of the final goods and services that an economy produces during a given year, accounting for inflation.
  • In other words, it is a macroeconomic measure of the value of the economy’s output adjusted for price changes (inflation or deflation).
  • It is calculated using the prices of a selected base year. To calculate Real GDP, one must determine how much GDP has been changed by inflation since the base year, and divide out the inflation each year.
  • The real GDP determines the purchasing power net of price changes for a given year.
  • It transforms the money-value measure, nominal GDP, into an index for quantity of total output.

Gross Domestic Product (GDP)

  • GDP is the final value of the goods and services produced within the geographic boundaries of a country during a specified period of time, normally a year.
  • GDP growth rate is an important indicator of the economic performance of a country.

Measurement of GDP:

  • Output Method:This measures the market value of all the goods and services produced within the borders of the country. GDP (as per output method) = Real GDP (GDP at constant prices) – Taxes + Subsidies.
  • Expenditure Method: This measures the total expenditure incurred by all entities on goods and services within the domestic boundaries of a country. GDP (as per expenditure method) = C + I + G + (X-IM) C: Consumption expenditure, I: Investment expenditure, G: Government spending and (X-IM): Exports minus imports, that is, net exports.
  • Income Method: It measures the total income earned by the factors of production, that is, labour and capital within the domestic boundaries of a country. GDP (as per income method) = GDP at factor cost + Taxes – Subsidies.
  • In India, contributions to GDP are mainly divided into 3 broad sectors – agriculture and allied services, industry and service sector.
  • In India, GDP is measured as market prices and the base year for computation is 2011-12. GDP at market prices = GDP at factor cost + Indirect Taxes – Subsidies

Significance of GDP:

  • GDP is used by economists to determine the health of the economy and whether an economy is growing.
  • GDP growth over consecutive quarters indicates the economy is expanding. If GDP growth and economic growth continue, this could signal that there might be a risk of inflation and policymakers should raise interest rates to help abate those consequences of growth.
  • If the GDP growth is negative over two or more consecutive quarters, this is considered a recession. This indicates to policy makers that measures to increase economic activity, like lowering the interest rate or printing more money, are necessary to maintain stability.
  • GDP data can also indicate how other countries or economic regions measure against each other.

The Drawbacks of Using GDP in Calculations:

  • GDP as a whole does not indicate standard of living.
  • It does not include any black market economies.
  • It also does not include other forms of unreported labor.
  • It does not include environmental costs of economic output.

GDP deflator is the ratio of real GDP to the nominal GDP. True OR False.

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Right statement 

  • GDP deflator is the ratio of nominal GDP to the real GDP.

Enrich Your Learning:

GDP Deflator

  • The GDP deflator is the ratio of the value of goods and services an economy produces in a particular year at current prices to that of prices that prevailed during the base year.
  • It is also called implicit price deflator which is a measure of inflation.
  • This ratio helps show the extent to which the increase in gross domestic product (GDP) has happened on account of higher prices rather than increase in output.

GDP Deflator calculation:

GDP Deflator             =          Nominal GDP  x 100
                                                      Real GDP

  • It is calculated by dividing nominal GDP by real GDP and then multiplying by 100.
  • Nominal GDP is the market value of goods and services produced in an economy, unadjusted for inflation which is the GDP measured at current prices.
  • Real GDP is nominal GDP, adjusted for inflation to reflect changes in real output which is the GDP measured at constant prices.

Difference between GDP Deflator and other Price Indices:

  • There are other measures of inflation too like Consumer Price Index (CPI) and Wholesale Price Index (or WPI), however GDP deflator is a much broader and comprehensive measure.
  • GDP deflator reflects the prices of all domestically produced goods and services in the economy whereas, other measures like CPI and WPI are based on a limited basket of goods and services, thereby not representing the entire economy.
  • Another important distinction is that the basket of WPI (at present) has no representation of services sector.
  • The GDP deflator also includes the prices of investment goods, government services and exports, and excludes the price of imports. Changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator which is not the case with other inflation measures.
  • WPI and CPI are available on monthly basis whereas deflator comes with a lag (yearly or quarterly, after quarterly GDP data is released). Hence, monthly change in inflation cannot be tracked using GDP deflator, limiting its usefulness.

What are the effects of increase/decrease of ‘Repo rate’ on Banking system as well as on economy of a country?

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Answer & Enrich Your Learning:

What is Repo Rate?

  • Repo rate refers to the rate at which commercial banks borrow money from the Reserve Bank of India (RBI) in case of shortage of funds.
  • Technically, Repo stands for ‘Repurchasing Option’.
  • It is a contract in which banks provide eligible securities such as Treasury Bills to the RBI while availing overnight loans.
  • As per February 2019, the repo rate is 6.25% per annum.

Effects of Repo rate:

Impact on the Banking System:

Increase in Repo Rate:

  • Higher lending rates which may lead to a slowdown of the lending business for the banking sector, which will have an impact on their profitability.
  • Higher equated monthly instalment for existing borrowers and higher rate of credit for new borrowers.
  • Banks may also hike the rate of bank deposit offered to customers to attract more inflow of funds into the banking system.

Reduction in Repo Rate:

  • Banks can borrow from Reserve Bank of India at a cheaper rate.
  • Banks may offer credit to its end customer at a reduced rate.
  • Increased lending business will boost the profitability of the overall banking system.

Impact of Repo rate on economy:

  • It is one of the main tools of RBI to keep inflation under control. In the event of inflation, RBI increase repo rateas this acts as a disincentive for banks to borrow from the RBI.
  • On the other hand, when the RBI needs to o flow cash into the system, it lowers repo rate. Consequentially, businesses and industries find it cheaper to borrow money for different investment purposes.

What is Reverse Repo Rate?

  • A Reverse Repo Rateis a rate that RBI offers to banks when they deposit their surplus cash with RBI for shorter periods.
  • As per February 2019,the reverse repo rate is 6.00%.
  • Reserve Bank of India increases the reverse repo rate with the objective to flush out the excess liquidity in the financial system by keeping check on inflation rate.

Significance of Repo rate and Reverse repo rate:

  • Repo and reverse repo are the most effective and efficient tools used by the Reserve Bank of India to achieve price stability and to boost economic development.
  • Repo rate and reverse repo rate are among the most crucial monetary policy instruments available to the RBI.
  • There is considerable rise in borrowing by commercial banks through repo route which makes it an important element of India’s monetary policy framework. The constant nature of the balance between Repo and Reverse-Repo makes it more powerful in the Indian banking system.

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