Question

1. what is a repurchase agreement and what is a reverse repo? how do they function and how do they differ? what does it represent? who are the main participants of the repo market? please explain clearly max in 6 sentences.

2. what are the lagged effects of the monetary policy. list all of them and explain each of them clearly. please explain each of the lagged effects max in one sentence.

3. what is global crowding out effect? explain this term max in 4 sentences.

Answer 1

1) Repurchase agreement: -

A repurchase agreement (RP) is a short-term loan where both parties agree to the sale and future repurchase of assets within a specified contract period. The seller sells a Treasury bill or other government security with a promise to buy it back at a specific date and at a price that includes an interest payment.

Repurchase agreements are typically short-term transactions, often literally overnight. However, some contracts are open and have no set maturity date, but the reverse transaction usually occurs within a year.

Dealers who buy repo contracts are generally raising cash for short-term purposes. Managers of hedge funds and other leveraged accounts, insurance companies, and money market mutual funds are among those active in such transactions.

- Reverse Repo: -

A reverse repurchase agreement (RRP) is an act of buying securities with the intention of returning—reselling—those same assets back in the future at a profit. This process is the opposite side of the coin to the repurchase agreement. To the party selling the security with the agreement to buy it back, it is a repurchase agreement. To the party buying the security and agreeing to sell it back, it is a reverse repurchase agreement. The reverse repo is the final step in the repurchase agreement closing the contract.

- How does a Repurchase Agreement works?

When companies need to raise immediate cash but don't want to sell their long-term securities, they can enter a repurchase agreement. Such agreements are common among large banks and other large financial institutions, but they work on the small business level as well. Raising cash is not free, so understanding your potential liabilities in a repurchase agreement can help you control the cost of putting extra cash on your balance sheet.

Selling Securities
Think of a repurchase agreement as a loan with securities as collateral. For example, a bank sells bonds to another bank and agrees to buy the bonds back later at a higher price. A business can engage in similar activity by offering certificates of deposit, stocks and bonds for sale to a bank or other financial institution with the promise to buy back the security at a later date for a higher price.

Buying Back a Security
Under the repurchase agreement, the financial institution you sell the securities to cannot sell them to someone else unless you default on your promise to buy them back. That means you must honor your obligation to repurchase. Failure to do so can hurt your credibility. It also can mean a lost opportunity if the security would have increased in value after your repurchase. You can agree on the buyback price at the time you enter the agreement so you can manage your cash flow to have funds available for the transaction.

The Repo Rate
You may hear the term "repo rate" when discussing repurchase agreements. This refers to a percentage you will pay to buy back securities. For example, you may have to pay a 10 percent higher price at repurchase time. If you think of this as interest, you can compare the benefit of a repurchase agreement against the cost of borrowing money form a bank.

Margin Payments
One potential cost of a repurchase agreement is margin payments. You have to make these when the value of the security drops before you repurchase it. The entity holding the security can ask you to pay extra money to make up for the loss of value. For example, if the security is a bond, and the market determines that the bond is no longer worth what it was when you entered the repurchase agreement, you must make a margin payment to compensate the company you sold it to.

-Difference between these two:

1) The significant difference between the Repo Rate and Reverse Repo Rate is that Repo Rate is the interest rate at which the commercial banks borrow loans from RBI, while Reverse Repo Rate is the rate at which the RBI borrows loan from the commercial banks.
2) The Repo Rate is always higher than the Reverse Repo Rate.

3) The Repo rate is a monetary tool used by the central bank for controlling the Inflation whereas a central bank uses reverse Repo Rate for controlling the supply of money in the economy.
4) The aim of Repo rate is to fulfil the deficiency of funds. On the other hand, the objective of Reverse Repo Rate is to ensure the liquidity in the economy.
5) Repo Rate is charged on Repurchase Agreement, whereas the Reverse Repo Rate is charged on Reverse Repurchase Agreement.

-Important sectors of the economy participate in the repo market: -
Significant participants in the repo market include the primary dealers, central banks, (including the U.S.
Federal Reserve in connection with its implementation of monetary policy), banks, insurance companies,
industrial companies, municipalities, mutual funds, pension funds and hedge funds. These entities all benefit
from the operational efficiency, security, and low funding costs available in the repo market.

2) Lagged effects of the monetary policy:

1. Data Lag:

Prima facie, policy-makers do not know what is going on in the economy exactly when it happens.

Typically, an economic change that starts at the beginning of the month becomes evident at the middle of the next month. So the data lag is about 1.5 months.

Lag 2. Recognition Lag:

Data for real economic variables are required over time as the government agencies receive more complete information. There is a recognition lag of at least two months because no policymaker pays much attention to reversals in data that occur for only one month.

Lag # 3. Legislative Lag:

Unlike fiscal policy changes, which occur only once a year, monetary policy changes occur at least twice a year or, in some countries, three to four times a year. So an important advantage of monetary policy is the short legislative lag. Monetary policy changes can be legislated quickly. But the legislative lag is a major weakness.

Lag # 4. Transmission Lag:

The transmission lag is the time interval between the policy decision and the subsequent change in policy instruments. This is also a more serious obstacle for fiscal policy than for monetary policy. For frequent changes in bank rate there is no transmission lag in case of monetary policy.

Lag 5. Effectiveness Lag:

The most important lag of monetary policy concerns the length of time required for an acceleration or deceleration in the money supply to influence real output. The effectiveness lag is long and variable and makes the value of the multiplier uncertain.

3) Global Crowding Out Effect: -

The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.

A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect.

In economics, crowding out is a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market.