Relation between Deflation and Bank interest rates: How does Deflation affect rates?

• Deflation, in simple terms is a sustained decrease in general price level.
• In other terms it can also be described as a situation in which less money chases excess goods, causing decrease in demand of goods and thus leading to a decrease in price.
• Thus if this demand created by less money can be curtailed, deflation would be contained.
• This is the genesis behind controlling deflation through monetary policy.

How the Deflation is controlled?

• If deflation occurs interest rates are reduced (ie)
• Both Repo and Reverse Repo rate in decreased.
• If repo rate is decreased, rate at which banks borrow from RBI is decreased, and so borrowing will become inexpensive and banks would thus either borrow more money or pass on this to their borrowers by increasing deposit rates
• Simultaneously, Reverse repo rate is also decreased, which tends to borrow more money from Central bank (RBI).
• In either of the cases, actual lending will be more and demand for goods and services will be more.

By this money flowing is increased in the country and to the people.