How Repo Rate and Reverse Repo Rate Control Inflation and Money Flow?
What is Repo Rate?
The interest rate at which the Reserve Bank of India or the Central Bank lends short term money to banks in the event of any shortfall of funds is called the Repurchase Rate or Repo Rate. Repo Rate essentially is used by monetary authorities to control inflation, credit availability and economic growth.
How Does Repo Rate Work?
When consumers borrow money from the bank, they charge an interest on the loan amount. This is called the cost of credit. So, when banks borrow money from the RBI during a cash shortfall situation, they also pay interest to the Central Bank on the amount borrowed. The rate at which they borrow money from the Central Bank is called the Repo Rate.
Who Decides the Repo Rate?
The Monetary Policy Committee (MPC) holds a meeting that is presided by the RBI Governor to decide the current Repo Rate or the Repo Rate for the following term.
What Is Reverse Repo Rate?
When there is excess liquidity in the market, the RBI borrows money from the banks. The rate at which the RBI borrows from the bank is called the Reverse Repo Rate. The banks receive interest for their holdings with the central bank.
What Is the Current Repo Rate?
Due to the damage to the Indian economy caused by COVID-19, the RBI has kept the Repo Rate unchanged at 4% in its first bi-monthly monetary policy for the year 2021. This decision has been taken to curtail the damage. Through the Repo Rate, the Central Bank infuses liquidity in the banking system.
What Is the Current Reverse Repo Rate?
The current Reverse Repo Rate is unchanged and stands at 3.35%.
Difference Between Repo Rate and Reverse Repo Rate
|Repo Rate||Reverse Repo Rate|
|RBI lends money to banks at the Repo Rate||RBI borrows money from banks at the Reverse
|Used for controlling inflation and cash deficiency||Used for managing cash flow|
|Involves selling of securities which are later
|Involves transferring of money from one account
|Higher than the Reverse Repo Rate||Lower than the Repo Rate|
How Repo Rate and Reverse Repo Rate Help Control Inflation and Cash Flow?
- High Repo Rate and Reverse Repo Rate: When the Repo Rate is high, banks borrow less money from the Central Bank because the cost of borrowing is high. When the Reverse Repo Rate is also high, the banks tend to keep more of their money with the RBI because they can earn higher returns.
- Low Repo Rate and Reverse Repo Rate: When the Repo Rate is low, banks borrow more money from the Central Bank because the cost of borrowing is low. When the Reverse Repo Rate is also low, banks park less money into the central bank, as it generates low returns.
What Are the Parameters of a Repo Transaction?
The RBI agrees to execute the repo transaction with the banks based on the following factors:
- Hedging & Leveraging: The RBI buys bonds and securities from the banks and provides cash to them in exchange for the collateral deposited.
- Controlling the Economy: The Central bank aims at controlling the economy and keeping inflation within the limit by increasing and decreasing the Repo Rate accordingly.
- Short-Term Borrowing: The RBI lends money to the banks for a short period of time. Later, the banks buy back their deposited securities at a pre-decided price.
- Cash Reserve/Liquidity: As a precautionary measure, banks borrow money from the RBI to maintain liquidity or cash reserve.
- Collaterals & Securities: The RBI accepts collateral in the form of bonds, gold, etc.